Weekly Global Intelligence Update
14 February 2000
Recession Time?
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."
[http://www.stratfor.com/services/giu/FORECAST/decadetocome/us2.asp]
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.
(c) 2000, WNI, Inc.
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