Strong Risk Of A Crash
By Colin Twiggs
November 24, 12:30 a.m. ET (4:30 p.m. AET)
USA
The Yield Curve Revisited
Earlier in the week I published a recession warning based on behavior of the yield curve over the past 12 months. Every time there has been a significant rise in short-term interest rates over the last 45 years, and the yield differential (maroon line) falls to zero, a recession follows.
treasury yield differential and recessions
The flat or negative yield curve squeezes bank interest margins, causing a tightening of credit and a consequent slow-down of consumer spending and new investment — which drags the economy into a recession.
Some readers may doubt the ability of the yield curve to precipitate a recession and instead blame extraordinary events such as the Gulf War (1991) and collapse of the dotcom tech bubble (2001). In the interests of fostering a wider debate on the forum, I will attempt to briefly address these issues here.
* Wars create uncertainty and can push the economy into a recession if they are seen as a serious threat to the country, as in WW1 and WW2, but smaller conflicts have a more stimulatory effect due to increased defense spending. Edward Leamer, professor of economics at UCLA, points out that defense spending on the Korean War rescued the economy from recession in 1951 and the Vietnam War performed a similar service in 1967. These are the only two times since 1946 that a housing collapse has not led to a full-blown recession. There is similarly no evidence to suggest that the Gulf War caused the recession in 1991.
* The US economy has proved itself resilient to one-off shocks like the collapse of LTCM in 1998; 9/11 in 2001 (the 2001 recession started in March and ended November according to the NBER); the collapse of Enron in 2004; and Hurricane Katrina in 2005.
* Similarly, the slow-down in computer software and hardware investment after Y2K would not on its own have caused a recession in 2001.
To cause a recession, a localized shock (such as the dotcom crash) needs to find a vector to spread the contagion thoughout the economy; in much the same way that a virus outbreak may cause an epidemic. The banking system provides such a vector because of the leverage effect: a $1 reduction in reserves can cause a $10 reduction in bank lending (and consequently in spending).
The latest subprime debacle was caused by banks attempting to circumvent the margin squeeze. They accepted narrower margins and on-sold loans into off-balance sheet SIVs, to avoid the reserve requirements. Lending on narrow margins is and always will be bad banking practice, no matter what clever structures are developed to hide this from investors/regulators. What the banks actually achieved was to leverage the problem into a far greater threat. According to the OECD, the banking system currently faces losses of up to $300 billion due to subprime mortgage foreclosures. Taking leverage into account, that would translate in a $1 to $3 trillion reduction in bank credit — and spending.
An Irresistible Force
If we examine short-term rates, a self-reinforcing cycle [A > B > C] is evident since the 1980s, with each recession requiring more severe rate cuts by the Fed in order to stimulate the economy. Every artificial reduction in interest rates, however, merely compounds the problem, requiring even deeper rate cuts in the next cycle.
treasury yield differential and recessions
It would be a mistake to ascribe falling interest rates solely to a decline in inflation. Money supply is growing at a steady click and there is strong evidence to suggest that purchasing power of the dollar is declining at a much faster long-term rate than the official consumer price index.
The market is more powerful than any individual or organization, including the Federal Reserve, who may be able to effect a temporary shift from the market equilibrium, but opposing pressure will gradually build until it becomes an irresistible force. By attempting to defer the inevitable, the Fed is digging us into a deeper and deeper hole, with each wave bigger than the last.
If you find yourself in a hole, the first thing to do is stop digging ~ Will Rogers.
Dow Jones Industrial Average
The Dow Jones Industrial Average made a clear break below its long-term trend channel, indicating a loss of momentum. Failure of support at 12800 would signal a primary trend reversal. Twiggs Money Flow shows a long-term bearish divergence (red) and a fall below -0.075 would warn that the primary trend is under threat.
dow jones industrial average medium-term chart
Short Term: Friday's volume was low due to the Thanksgiving long weekend and an early close on Friday. Expect some consolidation above primary support at 12800, but a downward breakout appears inevitable in the medium term, signaling reversal to a primary down-trend.
dow jones industrial average short term chart
Transport
The Dow Jones Transportation Average and Fedex (often a lead indicator for the broader economy) have both started primary down-trends, indicating that the economy is slowing. UPS is headed for a test of primary support at its March 2007 low.
dow jones transport and fedex
Small Caps & Technology
The Russell 2000 Small Caps index broke through support at 750, signaling the start of a primary down-trend. The declining price ratio (compared to Russell 1000) reflects the market shift towards the safety of large caps.
russell 2000 compared to russell 1000
The Nasdaq Composite is headed for a test of primary support at 2450. A Twiggs Money Flow fall below -0.06 would warn that the primary trend is under threat.
nasdaq composite index
S&P 500
The S&P 500 is headed for a test of primary support at 1400. Failure would signal the start of a primary down-trend. Twiggs Money Flow displays a large bearish divergence, warning of a reversal. Recovery above 1500 is not expected, and would indicate that the threat is over.
standard and poors 500
Faced with the choice between changing one's mind and proving that there is no need to do so, almost everyone gets busy on the proof ~ John Kenneth Galbraith.
|
