Stratfor: Recession Time?
February 14, 2000
stratfor.com
Summary
Last week, U.S. bond markets saw the emergence of a strange yield curve with the yield of 30-year Treasury bonds falling below earlier maturities. While there is argument over what this meant ? whether it meant anything at all ? the yield curve is one of several indicators suggesting that a recession is in the making. At the very least, the yield curve has flattened dramatically, and it seems to us that most market forces are driving toward an inverted yield curve. There are other signs, too. The performance of major stock indices has diverged. Commodity prices have risen, giving investment some place to go other than stocks. We remain bullish on the long-term prospects of the American economy but a short, sharp recession appears to be shaping up for late this year.
Analysis
Stratfor?s readers are aware that we have been consistently bullish on the U.S. economy. Our basic view of the U.S. market remains the one put forth in our recent decade forecast: ?Our expectation is that the massive growth spurt will continue for the first half of the decade. Though it would not surprise to see a sudden, very frightening downturn in the markets or a short, sharp recession, not dissimilar to 1987, the basic upturn will continue until at least 2005 and probably for several years hereafter.? Last week we started to see some indications that the ?short, sharp recession? that wouldn?t surprise us may be ready to not surprise us.
Our attention was riveted last week by the behavior of the ?yield curve? on U.S. Treasury instruments. The yield curve is simply the interest rate that purchasers of these instruments would receive, depending on the maturity date of the bill or bond. Under normal circumstances, the yield curve is positive. That means that the shorter maturities pay lower interest rates, while longer maturities pay higher ones; the 30-year Treasury Bond pays the highest. The reason is simple: People who buy longer-term bonds take greater risks because the government doesn?t have to redeem these bonds for 30 years. If interest rates rise, the value of the bonds on the secondary market could fall. People buying short-term bonds can be paid off in months or even days, and they don?t risk their investment principle.
One of the important precursors of recessions is a negative yield curve, in which short-term rates are higher than long-term ones. And one of the triggers for a recession is a rise in interest rates. Higher interest rates cause businesses to try to avoid long-term borrowing and seek short-term borrowing. The result: Short-term interest rates rise even higher than increases in long-term rates. This inversion of the normal yield curve is a classic sign of impending recession.
What we saw last week was a truly weird yield curve. The
three-month rate closed at about 5.7 percent, and the curve rose
steadily until the one-year yield was at a little more than six percent.
The yield curve was flat through three years, fell a bit at 10 years, and
fell again at 30 years to a yield of about 6.3 percent. There was a lot
of argument during the week about what this meant, with people
arguing that there was simply a lack of demand for the 30-year bond,
and that it therefore didn?t mean anything, since there was no piling
on at the short end.
There may be some truth to this argument, but it misses the key point,
which is that the yield curve is getting very flat. A year ago, the spread
between the short-term rate and the long bond was about 22 percent
of the short bond?s yield. Last week, it was about 10 percent. As
striking is the shift in just one week. Short-term rates rose about 0.2
percent while the long bond?s yield fell a little more than 0.3 percent.
The fact of the matter is that the short-term and long-term rates
behaved as they would prior to a recession. The mid-term rates did
not conform.
And all this took place this week, taking us from a fairly normal
positive curve to a dramatically strange curve ? indeed, an
unsustainable one. The question here is whether it will flip back to
positive or proceed to a negative curve. Our bet has to be that it will
move to an inverted, negative curve, because we cannot explain what
happened this week except as part of a transition. Healthy bond
markets do not produce these strange results and then flop back to
normal.
That is particularly the case with the Federal Reserve Bank clearly
following a policy leading to higher interest rates. Since the Fed?s
operations have much more control over short-term rates than
long-term ones, we expect that the flight from the long-term last week
? coupled with Fed policy ? will push up short-term rates at the
expense of mid-term ones, giving us a classic negative yield curve
fairly quickly. Since that will pull not only borrowers, but lenders as
well, on the short side of the curve, the final outcome should be a
classic inversion ? and a classical capital shortage.
The U.S. stock markets were also acting recessionary last week, with
a massive divergence developing between the highly speculative
NASDAQ, which reached new heights last week and the other
indices, which were fairly weak. The S&P 500, for example, crashed
below its 50-day moving average and wound up close to the 200-day
moving average. In simple terms, that stinks. And if the S&P were to
crash below the 200-day moving average, by following through on its
decline this week, that would stink big time.
A classic indicator of market tops is a divergence in indices. In
previous markets, people looked for divergence between the Dow
Jones average and the Dow Jones Transportation Index. Today, the
two critical economic sectors are high tech and everything else. With
the NASDAQ representing high tech, we see a tremendous
divergence now developing between the two sectors. Worse, the
NASDAQ seems caught in a classic buying climax that can?t be
sustained for very long. Either the rest of the market resumes its trend
upward, or the NASDAQ is going to be highly vulnerable.
One of the factors propping up the markets for the past half-decade
has been the lack of alternative places to park money. With
commodities at historically low prices and short-term interest rates
unattractive, buying stocks has seemed the only prudent course. With
short-term government interest rates moving toward six percent and
corporate paper even higher, the safety of money funds is no longer
quite so unattractive.
Even more interesting, of course, is the fact that commodities, long
languishing, are now booming, with gold leading the pack last week.
Higher commodity prices are also a precursor to recession, since
they raise the cost of production. Indeed, surging global production
has helped raise commodity prices, in a self-correcting process.
Virtually all commodities, with the exception of oil, moved higher last
week. Apart from being a recessionary sign in itself, the dramatic
moves in commodity prices give speculative money an alternative
arena in which to play, other than the stock markets.
If our thinking is correct, then we expect this to trigger a market
sell-off in the near future. The market is a leading indicator to the
economy, tending to move three to six months before the economy
as a whole. Thus, if we are to begin to see a substantial downturn in
the market in the next month or so, we could reasonably expect a
recession to hit during the summer and fall of 2000.
There are certainly indicators that argue against a market decline.
First, net free reserves, the measure of how much liquidity there is in
the banking system, remain heavily positive. That means that the
Fed, regardless of its management of interest rates, has not yet
dramatically tightened banking liquidity. Second, for all the talk of
speculative fever, the price-to-earnings ratio of the S&P 500 is no
higher than it was last year, and is in fact somewhat lower, reflecting
solid profits. By that measure, there is no reason for a correction.
Finally, in Stratfor?s absolutely unscientific survey, everyone is
convinced that the boom cannot go on much longer. There is such
absolute conviction that the good times must end, that we tend to
think they won?t.
Nevertheless, there is one good argument in favor of a short-term
recession: We are way overdue for one. Certainly there have been
major structural changes in the economy that have made the current
expansion possible. But the laws of the business cycle have not been
abolished; they?ve only been stretched. Tremendous inefficiency has
crept into the very sector that has driven the boom ? small
businesses. These businesses are experiencing severe structural
shortages, from skilled labor to office space, that limit the ability to
expand. Consider how the shortage of programmers inhibits the
ability of the software industry to expand, multiply it over other
industries, and you begin to see the limiting factor. It is time for a
pause.
Regardless of what the covers of Time and Newsweek may say in a
few months, it is not the end of the world, nor even the end of
capitalism ? nor the end of prosperity. If what we think is happening is
indeed happening, then this is merely a downturn in an economic
expansion that began in 1982, and it will resume after a few rough
quarters. We do believe there is more serious trouble looming later in
the decade, but to paraphrase Redd Foxx, ?This ain?t the big one.?
However, this does open a very interesting political vista: the 2000
presidential election being fought out in the context of a recession.
Recall how a minor downturn in 1991-92 cost George Bush the
presidency and delivered Bill Clinton to the White House. One of the
mainstays of the Democrats? polling numbers is the fact that the
economy has performed splendidly during Clinton?s presidency. It is
not clear that his policies made this possible, but nothing he did
prevented it. Voters have short memories. A recession, no matter
how mild, would make a Republican victory almost certain.
It would also awaken other sleeping issues, such as the trade deficit.
The deficit is massive, but tolerable in the context of a booming
economy. If the United States does go into recession later this year,
with rising unemployment and increasing business failures, the
question of foreign competition would certainly move to the fore. This
would dramatically increase tensions with Asia. A recession would
also close the door on any serious support for Russia?s economy,
assuming that door is not already closed.
If we knew what the stock market was going to do we wouldn?t be
working for a living, would we? And the stock market isn?t the
economy. Nevertheless, when we lay all the accumulating facts side
by side, it is difficult to avoid the conclusion that some serious
problems are developing. Obviously, the yield curve could correct
itself next week, and all this could go away. But with the Fed policy
being what it is, we find it hard to see how that curve can regain a
healthy upward angle. The more we look at it, the more it appears
that it may be time for a recession. |
