Inverted yield curve predicts 06 recession
But as today’s Wall Street Journal proclaimed, the inverted yield curve has finally arrived. This is important because the last six recessions have been preceded by an inverted yield curve.
The yield curve maps the interest rates that lenders charge those who borrow money over different periods of time. In an expanding economy, the short term interest rates, for say 2-year borrowers, are lower than the rates for long-term, say 20-year borrowers.
With such an upward sloping yield curve, banks can pay depositors, say 2%, while lending to long term borrowers at a higher, say 6%, interest rate. Such an upward sloping yield curve would let banks earn a 4% spread, encouraging them to lend out as much as possible. This lending would let borrowers finance purchases and investments -- leading to economic growth.
However, the Fed’s role is to stop inflation and such debt-fueled growth inevitably leads to inflation unless the Fed takes away the punch bowl by raising short-term interest rates. In the last 18 months, the Fed has done just that. Yesterday, the two-year interest rate rose above the 10-year rate by a fraction. If this condition persists and worsens, then that positive lending spread I mentioned above is wiped out.
Under such an inverted yield curve, it becomes more profitable for banks to hold onto their deposits and to force borrowers to repay their loans so the banks can invest the funds in short-term government securities. This lending retrenchment withdraws liquidity from the economy. Asset purchases financed by this lending slow down. Borrowers are forced to sell these assets to raise the cash needed to pay back the loans.
The quick asset sales cause asset prices to drop which leads to a decline in the ratio of the value of bank loans to the collateral backing them. Since these ratios are stipulated in the lending contracts, when the contract covenants are tripped, the banks have the option of demanding immediate repayment of the loans. This can cause a nasty and rapid tumble in the value of those assets.
With a rising rate at which banks book loans as uncollectible – particularly consumer loan charge-offs -- trouble may lie ahead for the economy which depends on the consumer for 70% of its growth. This is a particular concern considering that homeowners’ total and mortgage obligations are at a record 16.6% and 10.8% of disposable income.
Whether yesterday’s inverted yield curve is an aberration or a flashing danger signal remains to be seen. But if the current trajectory continues, a recession could be in the (credit) cards (and housing market) for 2006.
-----Original Message-----From: Peter Cohan [mailto:firstname.lastname@example.org] Sent: Monday, January 31, 2005 9:13 PMSubject: Are the yield curve and stock market predicting a recession?
The stock market began 2005 on a down note – declining 3%. However, a flurry of mergers announced in the last few days – coupled with apparent market relief over the results of the Iraqi election – seem to have changed investor sentiment.
But it appears way too early to predict a longer term trend based on one good day. In fact, one of the things that I find so fascinating about the stock market is that its behavior appears to defy rational explanation.
Most market commentators seem to operate according to several pet theories. The most popular seems to be that the stock market averages forecast the condition of the economy. Just for fun, let’s assume that the stock market forecasts the condition of the economy one year ahead. Applying this theory to 2003’s stock market would seem to fit pretty well in retrospect. Recall that the S&P 500 rose 29% in 2003 and as I note in this month’s The Cohan Letter, the economy had its best year since 1999 in 2004.
Playing along with this theory, the 9% increase in 2004’s S&P 500 would be forecasting far more modest economic growth in 2005. And the down market so far in 2005 would hint at a recession in 2006.
Another theory which I first learned about after reading William Greider’s Secrets of the Temple, is yield curve analysis. As Greider explained, when short term interest rates are lower than long term rates, the economy tends to expand. This expansion happens because banks can borrow money at low short-term rates and lend it out at higher long term rates. This so-called ‘carry trade’ allows banks to strengthen their balance sheets and lets corporations borrow enough money to expand their operations.
In the typical economic cycle, however, banks are tempted to lower their standards once their best quality credits have borrowed to their limit. At some point, inflation creeps into the economy and the Fed raises short-term interest rates so high that short-term rates exceed long-term ones – creating the ‘inverted yield curve.’ The inverted yield curve is an excellent recession predictor since it tends to make it unprofitable for banks to lend -- cutting off credit and accelerating economic retrenchment.
I will never forget an appearance I made on CNBC back in 1999 in which I noticed that the yield curve was becoming inverted. The reporter, Liz Clayman, asked me whether I thought that we were heading for a recession. And I am embarrassed to say that I had consumed enough New Economy Kool-Aid to answer ‘no.’
Of course a recession was not that far away. And as the yield curve flattens out, it may be that 2004’s modest stock market performance coupled with January’s negative result could be predicting another recession on the horizon. Let’s hope that our record levels of government borrowing don’t lead to a record level of retrenchment.