Monday, 3 November 2008

US economy shrinks, time to revisit the yield curve

The long-anticipated United States recession may finally be upon us.

On 30 October, the Commerce Department reported that the US economy contracted at a 0.3 percent annualised rate in the third quarter. According to the report, which is an advance estimate, the US consumer finally capitulated in the third quarter, with consumer spending falling by 3.1 percent, the biggest drop in 28 years.

The fall in real gross domestic product has been widely expected. The Institute for Supply Management's manufacturing index had plunged to 43.5 in September from 49.9 in August, 50 being the usual dividing line between expansion and contraction in the manufacturing sector. Employment has been falling since the beginning of the year. The yield curve had inverted in 2006. And various measures of the housing sector had been falling since 2005.

The fall in real GDP, assuming that the GDP is not subsequently revised upward, may or may not result in the National Bureau of Economic Research (NBER) declaring a recession beginning in the third quarter. The NBER normally looks at a wider range of indicators than just the GDP.

Still, the third quarter now looks like a good candidate for the beginning of the recession.

Assuming that the recession has begun, we next need to know how long the recession will last.

Historically, one of the earliest and most reliable leading indicators of the economy is the yield curve. In the current cycle, this indicator did indeed give a very early signal of recession. The term spread -- I focus on the spread between the 10-year Treasury yield and the 3-month Treasury yield here -- turned negative in the middle of 2006. This inversion of the yield curve is usually seen by economists as indicating tight monetary policy and signalling an impending recession.

In fact, assuming that the recession just started in the third quarter of 2008, the yield curve actually gave an unusually early signal. For the 1990 and 2001 recessions, the spread turned negative about a year or less before the onset of recession and turned positive just a few months before the recession began. This time around, it may have turned negative two years before the start of the recession and turned back positive about a year before the recession began.

Of course, there is always the possibility that the NBER eventually declares that the recession actually began in late 2007, as many economists in fact already think. That would make the yield curve signal conform closer to the norm.

The other possibility noted by economists is that the yield curve back in and around 2006 had been distorted by global capital flows and the shadow banking system, which allowed the yield on Treasury notes to remain unusually depressed even as short-term rates were raised by the Federal Reserve. In other words, monetary conditions were actually not as tight as the yield curve implied.

For all its possible flaws, however, the yield curve remains one of the more reliable leading indicators of the economy. So what is it telling us now?

According to Bloomberg, the yield curve has steepened considerably in recent months. As of Friday's close, the 10-year Treasury note yielded 3.96 percent while the 3-month Treasury bill yielded 0.38 percent. Therefore, the spread is a massive 3.58 percentage points. Historically, such a large spread often precedes a strong economic recovery.

Unfortunately, again, a simplistic interpretation of the spread may be wrong. In recent months, the yields on Treasury bills have been driven down by a flight to safety. In direct contrast to 2006, where the high short-term rate might not have accurately reflected easy monetary conditions, the low short-term rate today is not accurately reflecting the actual tight monetary conditions.

A better indicator of the tightness of monetary conditions today is the London interbank offered rate (LIBOR) for three-month US dollar loans. This rate has been driven up by credit concerns over the past few months and was well over 4 percent for much of October.

In fact, based on the LIBOR, the yield curve was inverted again in October. The spread between the 10-year Treasury yield and the 3-month US dollar LIBOR turned negative in late September and stayed so for most of last month, signalling possibly that a recovery in the economy is not imminent.

Still, things could change.

Policy makers continue to work actively to ease credit conditions. Just last week, the Federal Reserve cut the federal funds rate by 50 basis points to 1.0 percent. Several other central banks also cut interest rates last week, including the Bank of Japan. And over and above easier monetary policies, most of the major central banks have programmes to inject capital or liquidity directly at the areas considered most in need of them.

These actions will take time to bear fruit but there are already some encouraging signs.

The 3-month US dollar LIBOR fell back to 3.03 percent on Friday, down from 3.52 percent the previous week and well below its high of 4.82 percent for October. It is now below the yield on the 10-year Treasury note.

In other markets, global stock markets recovered strongly last week after suffering a pummelling earlier in the month. In the US, the Standard & Poor's 500 Index rose 10 percent last week to reduce its loss for October to 17 percent. In Europe, the Dow Jones Stoxx 600 rose 12 percent last week to finish the month down 13 percent. The MSCI Asia Pacific Index rose 7 percent last week and was down 20 percent for the month.

A recovery in the economy, however, will probably not be imminent until we see a sustained steepening of the yield curve and an upturn in stock markets.

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