US recession, dollar crisis and bond market meltdown

Fears of a recession in the United States and interest rate cuts by the Federal Reserve have pushed the yield on the 10-year Treasury below the rate of inflation. With the US economy looking likely to deteriorate further, the party for bond investors could continue for a while more, but there are dangers further out into the future.

Most of the recession talk surrounding the US economy have been based on the fall in employment in January and the decline in the nonmanufacturing index from the Institute for Supply Management (ISM) to 41.9 percent in January from 54.4 percent in December.

Manufacturing, in contrast, has provided a surprising pocket of strength. Factory orders rose 2.3 percent in December and the ISM's manufacturing PMI edged up over the 50 mark to 50.7 in January.

Nevertheless, the US economy is likely to see further weakness. The Federal Reserve's quarterly survey of senior loan officers in January found tighter lending standards, weaker demand for bank loans and a deterioration in the outlook for loan quality.

In the wake of the collapsing housing market and credit market turmoil of the past months, the findings from the Federal Reserve's survey certainly come as no surprise. Over the past few months, credit spreads have surged. The spread between Moody's Baa bond yield and the 10-year Treasury yield has doubled in the past year to over 300 basis points, a rise usually associated with recessions.

Such is the concern generated by such reports that policy-makers are already moving to provide stimulus to the economy. Last week, Congress passed an economic stimulus package while the Federal Reserve monetary easing recently accelerated with 125 basis points of interest rate cuts towards the end of January.

It is far from certain though that the Federal Reserve will continue to cut rates as aggressively in the coming months. Indeed, the past week saw several Federal Reserve officials, notably Dallas Federal Reserve President Richard Fisher, Richmond Federal Reserve President Jeffrey Lacker and Philadelphia Federal Reserve President Charles Plosser, say they remained concerned about inflation.

"The Fed has to be very careful now to add just the right amount of stimulus to the punch bowl without mixing in the potential to juice up inflation once the effect of the new punch kicks in," Fisher told the Instituto Tecnologico Autonomo de Mexico on 7 February.

Federal Reserve officials generally think a recession can be avoided. Wolfgang Munchau at the Financial Times is doubtful but nevertheless still skeptical of the benefits of further interest rate cuts by the Fed.

On 20 January, in an article entitled "America’s recession will be hard to shift", he warned that rate cuts could be counter-productive and cause long-term interest rates to go up instead of down "if bond markets start to distrust the Fed’s commitment to maintain a low rate of inflation".

Yesterday, in an article entitled "A repeat of the Great Depression is unlikely", he wrote that "the Fed is...seeking insurance against the possibility of a deflationary depression", but doubts that such an outcome is likely anyway.

"During the Great Depression, the US wholesale price index fell by 33 per cent," he wrote. "Such a price fall is not likely in our globalised economy."

The view of John Hussman, president of Hussman Investment Trust, is also interesting because he thinks that although asset prices are likely to be hit in a recession, losses in output and employment on the whole are not likely to be severe.

In an article entitled "A Writeoff Recession and a Dollar Crisis", Hussman pointed out that among the components of gross domestic product, downward pressure is likely to fall on housing and fixed investment. Consumption, in contrast, is usually stable and is likely to remain so. Furthermore, some of the contraction in demand would be absorbed by "a flattening out of the US current account". Meanwhile, because inventories are already "very lean", there is not likely to be much further retrenchment there.

"Rather, the current economic downturn is likely to focus its damage on asset prices," he wrote. Asset prices are likely to decline simply because they are "too elevated...to achieve an acceptable rate of return".

Losses in real economic output, however, "are unlikely to be dire".

And he may be right. In fact, the yield curve indicates that the outlook for the US economy may already be stabilising. The spread between the 10-year Treasury and short-term interest rates, negative for much of 2006 and 2007 and signalling a potential recession, has surged back into positive territory. This may be suggesting that even if the economy falls into recession, we can already see light at the end of the tunnel.

Or alternatively, it could be a sign that investors are pricing in higher inflation in the 10-year Treasury, just as Munchau feared.

In either case, it looks like the Federal Reserve needs to be wary of further aggressive rate cuts.

Indeed, both Hussman and Munchau see risks from an environment of depressed interest rates.

Hussman wrote that the low yields on Treasuries discourage capital inflow. That could trigger a US dollar crisis in view of the large current account deficit.

Munchau put it more starkly in his article yesterday. He wrote that if there is one thing that could produce a 1930s-style deflationary depression, it is a large-scale financial meltdown. In such a situation, lower central bank rates would not be very helpful.

On the other hand, if the recession turns out to be shallow and short, the 10-year US Treasury yield, now only about 3.7 percent and below the rate of consumer price inflation, might well shoot up to 6 or 7 per cent.

So if the Federal Reserve tries to insure against deflation, it might well risk "a bond market meltdown, your quintessential financial crisis".