Just because nominal long rates can’t go below zero, does that mean the U.S. won’t go into recession?
The yield curve has inverted prior to all of the last seven recessions, with no false signals since 1967, according to Estrella, whose website provides all kinds of research and data for the uninitiated.
Estrella uses the monthly average spread between the 3- month Treasury bill and the 10-year Treasury note to filter out the noise. The lead time between the appearance of a negative monthly spread and recession can be anywhere from three to 18 months. In the most recent instance, the spread turned negative in July 2006, and the U.S. economy slipped into recession in December 2007, according to the National Bureau of Economic Research, the official arbiter of the business cycle.
Under normal circumstances, the current spread of almost 300 basis points between short and long rates would be highly stimulative. Banks can borrow at next to nothing and lend to the U.S. Treasury, pocketing the difference. No fuss, no muss, no credit risk. The profit goes right to the bottom line, helping to recapitalize the banks, which will be in a better position to make loans to creditworthy borrowers.
While a steep yield curve is a sign of an expansionary monetary policy, the Fed needs the banks to get in the game. Instead they’re content to earn the equivalent of the funds rate on the $1 trillion of excess reserves they are holding in their accounts at the Fed.
In this way, the current cycle resembles the aftermath of the 1990 recession when banks, burdened with losses on commercial real estate, weren’t able to expand their balance sheets.
So the best thing the Fed can do if it is concerned about a faltering recovery is keep the funds rate at zero. The short rate is the more powerful tool when it comes to moving the economy. (If it weren’t, why does every central bank in the world target a short rate?) That’s true even though most of us can’t borrow at the interbank lending rate of 0 to 0.25 percent.
“If corporations and banks can fund themselves at zero, credit would not be a problem,” Estrella says. “You could have slowdown for some other reason.”
Slowdown, yes; recession, no. That’s the message of the yield curve. Its track record is impeccable. It beats forecasters, econometric models, even the Fed, which seems to resist the inherent message in the spread.
For all those double-dippers still splashing around in the pool, it’s time to get out, towel off and learn to love a slow recovery.
Wednesday, July 14, 2010
Yields Curves, Recessions and Double Dips
From Caroline Baum of Bloomberg: