Thursday, September 9, 2010

Is There Another Recession Around the Corner?

The best indicator of a recession has been the Term Structure of Interest Rate, better known as the “yield curve.” When the yield curve inverts, the economy slips into a recession approximately 4 - 6 quarters later. For my explanation of why this occurs, you can read my article here: http://pcpe.libinst.cz/nppe/1_1/nppe1_1_1.pdf or you can read the full dissertation here: http://mises.org/etexts/cwik-dissertation.pdf.


The yield curve has been making some troubling signs. Typically, the yield curve has an upward slope, and it looks like this:



However, when the economy reaches the upper turning point and is poised to fall into a recession, the short-term end rises relative to the long-term end. When this happens, it is called an inverted yield curve. We can plot the slope of the yield curve by simply taking the difference between the long and short ends. When the yield curve is upward sloping, the difference is a positive number. When the yield curve inverts, we have a negative number.

Here is a chart illustrating this difference over the past ten years:


(You can click on this picture for a close up.)

As we can see, the difference is falling again. The 10 year – 3 month spread dropped more than a 110 basis points from a recent high of 3.69 in April to 2.54 in August. The 10 year – 1 year spread dropped almost a 100 basis points from a recent high of 3.40 in April to 2.44 in August. The 20 year – 3 month spread dropped 101 basis points from a recent high of 4.37 in April to 3.36 in August. And the 30 year – 3 month spread dropped almost a 100 basis points from a recent high of 4.53 in April to 3.64 in August.


Each of these indicators fell by about 100 basis points in only 5 months, from April to August. This is a very sharp decline. The Fed has been absolutely flooding the market with as much money as the market can take. Many economists think that the Fed is running out of room to maneuver. 3-month T-Bills are under .20% and have been since April of 2009. 1-year T-Bills are now under .25% and with the Fed stimulant, there is a continuing downward trend. The question on the table is how long will this untenable situation remain?


When we see short-term interest rates start to rise, we will not the long-term rates follow suit. I am expecting to see the yield curve continue to flatten. If trends continue as they are, we are staring at a potential second dip in this recession.

5 comments:

Madame Or said...

Sorry to blow your bubble but Quantitative Easing is over since August 25, secretly and unobserved, Quantitative Tightening is now on:


Operation TWIST Again: Quantitative Tightening


Giving Tempo to the TWIST.


Operation TWIST Again: Market Crash Cheap Date.


Update you Software

P F Cwik said...

I don't see how the claim that the Fed has stopped monetary easing has burst "my bubble." In fact, if the Fed has stopped monetary easing, then I would expect short-term rates to climb. With short-term rates climbing and long-term rates falling, I would think that the time table for a yield curve inversion would be expedited.

I think that the second dip is long overdue because we have not cleared out the malinvestment that were built up over the past decade. Either we have to go through a painful liquidation process or we need more savings (or both). Without a structural political change, I don't see how more savings will be attracted to the US. Thus, it looks like our future is that of a second dip.

Darryl Mitchell said...

So, assuming we are headed into a second recession (or "dip"), do you expect it to be longer or shorter than the last one? How do you think Bernanke's recent announcement that the Fed will be prepared to "dig deeper, if necessary, to stimulate the economy" will factor into this? It seems contribute to your idea, and seems to me they are doing more harm than good at this point. You can only plug a leaking dam so much before it bursts.

Article here: http://www.nytimes.com/2010/08/28/business/economy/28fed.html?_r=1

P F Cwik said...

Darryl,

The Fed has fewer options in front of it than when the recession began. The Fed may attempt to lower interest rates in an attempt to stimulate the economy through credit expansion. I think that this approach will be largely ineffective because 1) with interest rates as low as they are, there isn't much to cut, and 2) the problem is the lack of business confidence not liquidity.

The Fed is certainly willing to pump as much money into the system as the economy will hold, but the problem is that there is too much uncertainty. The result is that investors are sitting on the sidelines waiting to see what will happen.

If we truly want a recovery we need more savings. The best way to get savings, if Americans are unwilling to save, is by attracting it from around the world. That means we need a business climate that is superior to any other place in the world. With taxes set to increase, with regulations expanding, with new and evermore burdensome regulations about to start, are we setting ourselves up for success?

I very much doubt it.

P F Cwik said...

UPDATE: It is now mid-October and the spread is still falling! The 30-year spreads are down to about 3.55%. The 20-year spreads are around 3.22%. The 10-year spreads are around 2.27%.

The larger point is that they are still falling. The short-term rates are being held very low by the Fed. It is the long-rates that are coming down.

Is it only a matter of time before the market is able to overcome current Fed policy? When short-rates jump up, it is a clear signal that the next dip is around the corner.

Post a Comment