SERIOUS MONEY:THE MONTH of August is finally over and not before time, as the peak holiday season was interrupted by levels of stock market volatility not seen since the darkest days of the financial crisis during the autumn of 2008. The increased uncertainty was more than evident in the Chicago Board Option Exchange's (CBOE) Volatility Index, which reached levels early in the month that exceeded the extremes recorded following the 9/11 terrorist attacks a decade ago and, after the high-profile corporate scandals and subsequent bankruptcy of WorldCom during the summer of 2002.
The sell-off that began earlier in the summer gathered pace during the month, as investors absorbed an almost relentless flow of economic data that fell well short of expectations. This suggested that the world’s largest economy may soon succumb to a double-dip recession for the first time since the 1930s.
Against this background, the tension could not have been more palpable in the build-up to Ben Bernanke’s speech to central bankers at the annual economic symposium in Jackson Hole.
With economic momentum at a standstill, investors were hopeful that the Federal Reserve chairman would inject life into an ailing bull market, via a strong hint that a further round of quantitative easing was imminent, just as he did at last year’s conference.
Indeed, Bernanke’s remarks last year kick-started the bull market and stock prices ultimately climbed by more than 26 per cent before the second round of quantitative easing concluded at the end of June.
Investors reacted enthusiastically to Bernanke’s ruminations – in a repeat performance of last year – even though there was little substance to warrant the Wall Street cheer. Indeed, the Fed chairman simply reminded his audience that the central bank had a “range of tools that could be used to provide additional monetary stimulus”.
Furthermore, the frank admission that the “recovery from the crisis has been much less robust than we had hoped” should have raised concerns over the potency of quantitative easing in the face of continued private sector deleveraging.
Importantly, the bond market does not share equity investors’ enthusiasm and indicators suggest that a recession is imminent.
The yield curve or spread between short-term and long-term interest rates is the best leading indicator of economic recession by far, and an inverted or humped curve has occurred no more than six quarters before every business downturn since the 1950s. The curve issued just one false signal in the past 50 years; the spread between short-term and long-term rates turned negative from September 1966 through January 1967, but no recession followed. However, the economy was buoyed by the expansion of government expenditures arising from the military build-up in Vietnam – the private sector did indeed enter a downturn and investors endured a bear market decline in stock prices.
The current spread between short-term and long-term interest rates is close to 200 basis points, and, based on the historical record, this suggests that the odds of recession within the next 12 months are about one in seven. However, it is important to appreciate that the spread between short-term and long-term interest rates loses its usefulness when short-term interest rates are close to the zero-bound.
Long-term rates reflect the markets’ expectation of future short-term rates, and the curve inverts when participants anticipate aggressive monetary easing by the Federal Reserve in the face of a weak economy.
However, the Fed cannot reduce short-term interest rates when they are already at the zero-bound. Consequently, long rates must stay above short rates, because the Fed may hike short rates at some point in the future, but it can’t cut them while they are at the zero-bound.
The experience of both post-bubble Japan and the US during the Great Depression is instructive in this regard. Long rates remained above short rates in Japan throughout the 1990s and the spread was 170 basis points when the economy slipped into recession in 1997. The yield curve inverted in the US in January 1928, well before the economy peaked in late summer the following year. However, the indicator lost its usefulness during the 1930s and, just like Japan, failed to warn of an impending recession before the economy turned down in the spring of 1937. The bottom line today is that five-year yields of just 1 per cent and 10-year yields of 2 per cent suggest the economic outlook is not pretty.
Equity investors will be quick to dismiss the yield curve’s message, but they have done so before, and to their cost. They ignored the indicator at the turn of the millennium, arguing that the recession signal was no longer relevant due to the bond shortage arising from sizable fiscal surpluses as far as the eye could see.
The mistake was repeated once again in 2007, as the yield curve inversion was blamed on price-insensitive central banks recycling their current account surpluses into dollars to prevent the appreciation of their own currencies. Both episodes were followed not only by economic recession, but savage bear markets that brought overweight equity investors to their knees.
The yield curve has issued a recession warning, but equity investors are not impressed and stock prices have moved well above their recent lows. Investors should be aware, however, that the yield curve leads stock market performance. Will the indicator strike again? The historical record is in its favour.
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