Everywhere you turn, recession is staring you in the face.
Sunday’s The New York Times featured a story on the prospects for recession on the front page of Week in its Review section. The following day, The Wall Street Journal (which has an exclusive content partnership with Mint in India) ran a recession article on page one.
Across the pond, Harvard’s Larry Summers made waves in a 26 November Financial Times column, in which he said “the odds now favour a US recession.” Newspapers in Europe and Asia are commenting on comments on recession.
Economists are scurrying to pencil in another reduction in the Federal Reserve’s benchmark rate on 11 December and to pare their target for next year, comments by policymakers notwithstanding. Less than two weeks ago, Fed governor Randall Kroszner was surprisingly blunt when he told an industry conference that “the current stance of monetary policy should help the economy get through the rough patch during the next year.” Data consistent with the slow growth he foresees won’t suggest monetary policy is “inappropriate,” he said.
The message was clear: No rate cut in December. Unfortunately, the market’s outlook isn’t aligned with the Fed’s forecast. The Fed funds futures market is placing the odds of a 25 basis points cut on 11 December at 98%. Economists had initially put their faith in the Fed’s words. Now they’re siding with the market’s action.
So, is all this recession talk overblown, a good story to explain teetering world stock markets? What hard evidence is there the economy is rolling over? “The thing that makes it most compelling is that the consensus of economists is still looking for growth,” says Paul Kasriel, director of economic research at the Northern Trust Corp. in Chicago.
For those putting their faith in markets, one glance at the US treasury yield curve tells you something is amiss. The yield on every issue, from bill out to bond, is below the Fed’s target rate. That’s an unnatural state of affairs that violates Rule No. 1 of banking: borrow short, lend long. It makes it harder to turn a profit, which is one of the reasons financial stocks have been the biggest losers this year.
The spread between the funds rate and 10-year treasury yield, which is one of 10 components in the Index of Leading Economic Indicators (LEI), has been inverted since July 2006 on a monthly average basis.
Given that the US economy was still expanding in the third quarter—at close to a 5% pace, if estimates for tomorrow’s revision are correct—the spread’s lead time looks to be long.
All the talk about why long rates have been low—dollar-related buying by the People’s Bank of China, the global savings glut, and now a panicked flight-to-quality—is beside the point. The message of the yield curve is that the Fed is keeping the overnight rate too high relative to long-term rates.
There are other troublesome signals. The spread between high-yield bonds and gilt-edged government securities has more than doubled since June to about 500 basis points. “Credit spreads are usually a coincident to lagging indicator,” Kasriel said. “The fact that they’ve widened may suggest we’re already in” recession. Three-month interbank lending rates are up, and central banks in both the US and Europe are acting to ease anticipated year-end funding pressures.
The Fed announced earlier this week that it plans to conduct “term repurchase agreements,” which are collateralized loans to primary dealers, that will extend into the new year. Ever since credit concerns arose in August, the effective fed funds rate has been wide of the Fed’s target.
What else is sending a worrying sign? The LEI has been going sideways for an unprecedented two years. That suggests the US economy doesn’t have “significant upward momentum going forward,” said Ataman Ozyildirim, an economist with the Conference Board’s business cycle indicators group. “It highlights the risk in the economy.”
It is not, in his view, sending a recession signal. Of the two measures whose readings presage a slump—the six-month annualized change in the LEI and the six-month diffusion index—only one is in danger territory.
The six-month diffusion index was at the threshold of 50 in September and October, indicating that half of the 10 components were rising in the last half-year. That index stood at 40 for the entire first half of 2007, seemingly without any untoward effects. The six-month change in the LEI has been hovering near zero for a year and a half, well shy of the 4-4.5% decline Ozyildirim says meets the threshold for a recession signal. The recent trend in the LEI is not encouraging: The index posted steep declines in two of the last three months. Falling home prices, rising default rates, sagging consumer confidence and tighter lending standards may prove to be the proverbial straw that broke the economy’s back.
“Banks are buying old credit, not making new loans,” Kasriel said. “You could say there’s a reintermediation going on. Banks are buying the assets no one wants.” That’s not the making of a healthy economy. Bloomberg
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