The Yield Curve Speaks

July 16, 2013

The yield curve is a measurement of the relationship between short-term and long-term interest rates. When long-term rates are high relative to short-term rates, the economy is typically strong. The opposite case is not so rosy—when short-term rates are higher than long-term rates, a recession is often in the offing.

Mark Hulbert of Marketwatch makes this point about the yield curve in a recent column. He writes:

You’re wrong if you think that interest rate increases over the last month are bad for the stock market.

That’s because not all rate hikes are created equal. And the kind that we’ve seen over the last month is not the type that typically kills a bull market.

In fact, a strong argument can be made that the last month’s rate increases are actually good news for the stock market: Because the greatest increases have come at the longer end of the maturity spectrum, the yield curve in recent weeks has become steeper — just the opposite of the direction it would be heading if the odds of a recession were growing.

Later in the article, Mr. Hulbert quantifies the chances of a recession based on the yield curve indicator.

It’s a shame that because of concern that the yield curve might be manipulated, many in recent years have tended to dismiss its utility as a leading economic indicator. Its record, in fact, has been creditable — if not impressive.

Consider one famous econometric model based on the slope of the yield curve that was introduced more than a decade ago by Arturo Estrella, currently an economics professor at Rensselaer Polytechnic and, from 1996 through 2008, senior VP of the New York Federal Reserve Bank’s Research and Statistics Group, and Frederic
Mishkin, a Columbia University professor who was a member of the Federal Reserve’s Board of Governors from 2006 to 2008. The model last spiked upward in late 2007 and 2008, when it gauged the odds of a recession at more than 40% — just before the Great Recession. Click here to go to the page of the NY Fed’s website devoted to this model.

Today, in contrast, the model is reporting the odds of a recession in the next 12 months at a minuscule 2.5%.

Now, I have no way of knowing or even guessing if the yield curve will be accurate this time around, but it’s worth noting in the sea of bearishness surrounding the recent increase in long-term interest rates. When pundits are nearly unanimous, it’s always worth considering if the opposite might in fact be the case.

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Recession Watch 2013

June 28, 2013

Every time the market corrects, pundits start looking for a recession. It’s not a crazy idea, since the S&P 500 is a leading indicator of the economy. Recessions are typically led by market corrections, but market corrections have also forecast ten of the last two recessions. The stock market alone is not a reliable indicator.

Those voting against the recession idea often cite the steep yield curve as a sign the economy is strong. (See, for example, here and here.) Recessions typically are preceded by an inverted yield curve, where short-term yields are higher than long-term yields, and we are far from that right now.

Those voting in favor of the recession point out a variety of weakening data series that often forecast recessions, especially new order indexes, credit spreads, and oil prices. (See, for example, here, here, here, and here.) Earnings and revenues are decelerating and that causes economists to fear for the future. Many indicators of this type are not actually negative yet, but the fear is that they will become so.

The truth is that no one knows what will happen.

You are right to be skeptical of economic forecasts. Most economists did not see the 2008 housing bust and recession coming—and on the other side of the coin, a few economists are still stubbornly clinging to their 2011 recession calls. The market corrected sharply, the economy slowed, but a recession was ultimately avoided as the economy picked back up.

Part of the rationale for the way we do tactical asset allocation is that we do not have to forecast—we change when the relative strength of asset classes or sectors changes. The biggest problem with forecasting is that people tend to have an opinion, which they proceed to back up by only looking at confirming evidence. Both bulls and bears can always point to signs of improvement or signs of deterioration. Trend following avoids that whole problem and just goes with the flow. As market expectations change, holdings in a relative strength portfolio change right along with them. Trend following is never ideal, but it’s mostly in the ballpark most of the time—and it’s way less stressful than worrying about the economy constantly.

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The Truth About the “Impending” Recession

August 15, 2012

Doug Short at Advisor Perspectives performs a very valuable public service. He presents very clear charts of major economic indicators without a lot of heavy interpretation and spin. Pundits who have forecast a recession—and therefore have a vested interest in a recession occurring—often pick and choose their indicators. There’s always some part of the economy that’s lagging, and with the right spin you can probably make it look like the sky is falling.

Here is Mr. Short’s brief comment:

Official recession calls are the responsibility of the NBER Business Cycle Dating Committee, which is understandably vague about the specific indicators on which they base their decisions. This committee statement is about as close as they get to identifying their method.

There is, however, a general understanding that there are four big indicators that the committee weighs heavily in their cycle identification process. They are:

  • Industrial Production
  • Real Income (excluding transfer payments)
  • Employment
  • Real Retail Sales

The weight of these four in the decision process is sufficient rationale for the St. Louis FRED repository to feature a chart four-pack of these indicators along with the statement that “the charts plot four main economic indicators tracked by the NBER dating committee.”

Bear in mind that the NBER dating committee identifies recessions after the fact. These are not leading indicators, but rather coincident indicators. Only after they have turned down solidly can the NBER agree that a recession has started.

So, what do the indicators actually look like? There are more charts in Mr. Short’s indicator update, but this chart summarizes it nicely.

BigFour The Truth About the Impending Recession

Are these indicators going up or down?

Source: Advisor Perspectives/Doug Short (click to enlarge)

I highly recommend reading the entire article, but even a cursory inspection of this chart shows no current evidence of a recession. The stock market is one of the leading indicators in the LEI also, and it is near the high for the year. Our global tactical allocation accounts hold a lot of domestic equity because that’s where the strength has been. (Despite, or maybe because of, investors’ reluctance to own stocks, the market is having a decent year so far.) Instead of freaking out about an impending recession, maybe you could just look at the primary source data.

It’s not impossible that a recession is on the way, of course, but you’d have to present data that the NBER is not using. Anything can happen, but it’s pretty tough to make the recession argument from the data in this chart.

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