By Lance Roberts
You are being lied to. There is currently
more than sufficient evidence that indicates that we are either in, or about to
be in, a recession. The last time I made that statement was in December of
2007. In December of 2008 the National Bureau of Economic Research stated that
we were correct. I don’t make statements like that lightly and, honestly, I
hope I am wrong as this is a horrible time for the economy to relapse.
However, the reason that I bring this up is
that there have been numerous analysts and economists stating that the economy
cannot be going into recession due to the spread between various sets of
interest rates. (For the purpose of this report
we will focus on the spread between the 1-year Treasury bond and the 10-year
Treasury note.) Historically speaking they would be correct and I will
explain why.
The steepness of the yield curve has been
an excellent indicator of a possible future recession for several reasons.
First, the spread is heavily influenced by current monetary policy which has a
significant influence on real activity over the next several quarters. When
there is a rise in the shorter rate this tends to flatten the yield curve as
well as to slow real growth in the near term. This relationship, however, is
only one part of the explanation for the yield curve’s usefulness as a
forecasting tool. The steepness of the curve also reflects the expectations of
future inflation. Because economic growth is affected by the level and trend
of both interest rates and inflation it is not surprising that the spread has
historically been a good predictor of future recessions.
This time it could be wrong.
The issues with the spread between interest
rates today are twofold. First, the U.S., via the Federal Reserve, has
embarked upon an unprecedented series of policies to deliberately suppress the
yield curve. Through outright purchases of treasuries through Permanent Open
Market Operations (POMO) and Quantitative Easing (debt monetization) programs
have been implemented to specifically target areas of the interest rate curve.
Even the recent announcement of “Operation
Twist” is specifically designed to flatten the yield curve to “help promote the demand for credit”.
Therefore, since abnormal and artificial influences are being applied to the
bond market to manipulate interest rates it removes the usefulness of the yield
curve as a forward indicator of recessions.
Secondly, and most importantly, the economy
is currently not operating under a normal economic environment. As we have
discussed in recent missives the U.S., for the first time since the “Great Depression”, is undergoing a balance
sheet recession. During the “Great
Depression” beginning in 1929, the Total Credit Market Debt as a percentage
of GDP rose substantially before eventually collapsing. We saw this phenomenon
begin again in the 1980′s as total debt began to expand dramatically until the
Total Credit Market Debt hit 380% of GDP in early 2009. We are now experiencing
the deleveraging of those credit excesses which creates economic drag as money
is diverted from savings and consumption to the repayment of debt.
Japan has been struggling with the same
reality since the bursting of their real-estate/credit bubble and subsequent
balance sheet recession. The government of Japan has implemented many of the
same policies that Ben Bernanke has been foisting upon the US economy but to no
avail. As a result Japan has been mired in a stagnating/declining economic
growth environment for the last two decades with frequently recurring
recessionary downturns.
The yield spread between Japanese bonds,
much like we expect to happen here in the U.S., has remained positive due to
government interventions since the beginning of their economic malaise some two
decades ago. As far as a recessionary indicator goes – the yield spread has
failed miserably.
Japan has been struggling with the same
declining employment to population ratio, stagnating wages, an overburdened
pension system and weak economic growth enviroment that currently faces the U.S.
today. If that is the case then the economic future that has been laid out
before us is not a bright one. The coming deleveraging of debt which will
result in a needed cleansing of the excesses from the system will result in
continued weakness in economic growth as consumers and businesses remain on the
defensive. This defensive posture leads to deterioration in the demand for
credit, stagnation of wages and lack of productive investment.
If the recent history of Japan is any
reflection of the path that we have been set upon then we will likely enter a
recession by the beginning of 2012. Of course, it will confound, confuse and
surprise the mainstream analysts and media as the yield curve will most likely
remain positive. As I stated before, I sincerely hope I am wrong, and that
everything turns out for the best. Deep down I am an enternal optomist and
believe in the innovation, ingenuity and passion that has made this country
great. However, “hope” and “optimism” are not investment strategies by
which we can successfully navigate the finanical markets today or in the
future.
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