In the Year of the Rat, will the US economy fall into the sewer?

China celebrates the beginning of a new lunar year this week. On the opposite side of the world, we may be seeing the beginning of the end of the economic expansion of the past few years.

The past two weeks have been very eventful for those following the United States economy. The highlights must surely be the two Federal Reserve interest rate cuts on 23 and 30 January by 75 basis points and 50 basis points respectively and the latest report on Friday that US employment shrank in January. Volatility in markets also added to the excitement.

For China and many other countries in East Asia, another form of excitement is approaching. On 7 February, they will be celebrating the beginning of a new year in the Chinese lunar calendar. According to the Chinese calendar, this coming year is the Year of the Rat.

Feng shui master Raymond Lo says on his website that this coming year is symbolized by two elements: earth sitting on top of water. He says in his remarks on the economy in 2008 that in the absence of the fire element, "investors will play cool and conservative".

Lo says that the industries that will perform well in the coming year will be industries related to the earth and metal elements, such as property, hotel, mining, insurance, machinery, engineering, health, computer and high tech industries. The sectors that will not do so well will be those related to water, such as shipping, communication and drinks, and fire, such as the stock market, finance, energy, electricity and entertainment.

Lo adds that it will be "a year of cooling down after the heated economic atmosphere in 2006 and 2007".

At the moment, though, the start to the Year of the Rat in China is looking much too cool for comfort. Cold weather and snow storms have caused deaths and disrupted electrical power and transportation in much of the country. It is not exactly a great time to celebrate.

Economically though, the draught may hit the United States first. The US economy, the engine of global growth for the past few years, is looking shaky and may fall into recession, dragging down China and the rest of the world economy.

Last week's data provided ominous signs for the US economy. On Wednesday, the Commerce Department reported that the US economy grew at an annual rate of just 0.6 percent in the fourth quarter, weaker than most economists had expected. Then on Friday, the Labor Department reported that non-farm payrolls in the US fell by 17,000 in January.

To keep things in perspective, though, note that these do not provide conclusive proof that the economy is in or even necessarily close to a recession. Remember that the non-farm payroll number is likely to be revised in subsequent months. Furthermore, the household survey did show an increase in employment in January and the unemployment rate dipped slightly to 4.9 percent from 5.0 percent in December.

Nevertheless, employment growth in the US is clearly in a weakening trend.

Perhaps more significantly, the Institute for Supply Management (ISM) reported on Friday that its manufacturing PMI rose to 50.7 in January from 48.4 in December, indicating that manufacturing is not yet contracting. In fact, according to the ISM, a PMI in excess of 41.1 percent generally indicates that the overall economy is expanding.

Nevertheless, over the longer term, the PMI, like the employment numbers, is also on a declining trend, indicating a weakening economy.

The weak trend was corroborated on Friday by the Economic Cycle Research Institute (ECRI). The ECRI's Weekly Leading Index (WLI) fell to 131.1 in the week to January 25 from 135.7 in the prior week and its annualised growth rate fell to minus 7.1 percent, a six-year low, from minus 6.0 percent.

Some analysts have noted that the yield curve, another oft-cited leading indicator of the economy, has been steepening in recent months, which could be positive for the economy. For example, the spread between the 10-year Treasury and the 2-year Treasury, negative for much of late 2006 and early 2007, is now well in positive territory at about 1.5 percent.

However, this particular indicator has a very long lead time. Its rise perhaps indicate that there is light at the end of the tunnel for the economy.

For an indication of where the economy is headed over the next few months, however, the spread between the 2-year note and the federal funds rate may be a better indicator. This indicator, though, is showing a very different picture.

Over the past few months, the spread between the 2-year note and the federal funds rate has dived. It fell to nearly -2 percent last month before the fall was arrested by the Federal Reserve's two interest rate cuts over the past fortnight amounting to 125 basis points.

In the past twenty years, there have been two other times when the spread between the 2-yr Treasury yield and the federal funds rate fell sharply into negative territory on a similarly sustained basis. One was in late 2000 and early 2001, just before the last confirmed US recession. The other was in 1989, just before the prior recession in 1990.

On both those occasions, this spread continued to fall even as the spread between the 10-year and the 2-year was turning positive after its own sojourn into negative territory. The divergence in both those instances was driven by a fall in the 2-year yield, just as it is now.

Although this also does not prove that a US recession is imminent, Lakshman Achuthan, managing director at ECRI, probably said it correctly when he released the institute's WLI: "While the economy and employment did continue to grow through the end of 2007, the window of opportunity to avert a US recession is about to slam shut."