Probabilities of Recession

John Mauldin | Thoughts from the Frontline
February 24, 2006

This week we look at the possible direction of interest rates both at the long end and the short end. Bottom line: history suggests there is some serious volatility in the future on the long end of the interest rate curve later in the year. The yield curve and the 6/50 Rule when looked at together reveal some very interesting insights. (This letter may print longer than usual, but that is because there are a lot of charts. In words it is actually shorter than most letters.)

But first, I want to once again mention that I along with my partners Altegris Investments will be hosting our third annual Strategic Investment Conference in La Jolla, California next May 18-20. As usual, we have a powerhouse lineup of speakers. Martin Barnes of Bank Credit Analyst, Dennis Gartman, Richard Russell, Louis-Vincent Gave, Mark Finn and my personal (as well as someone called Oprah's) doctor Dr. Michael Roizen (who wrote the RealAge series of books and the recent blockbuster bestseller You - The Owner's Manual). With this lineup you can expect not only solid information and some fun, but some very serious debates. One of my rules in designing a conference is to get speakers who are going to help make me a better investor and analyst. I think we have done that and more this year.

Due to regulations, we must limit attendance to "qualified" individuals and all attendees must be approved in advance. "Qualified" in this sense is a legal term which designates certain levels of net worth and not meant to say that all of my readers are not excellently qualified and astute analysts of investments and the markets. In general this means to attend you must have $2 million or more in investments, or be institutional investors. While I wish I could open up the conference to all of you, I do not make the rules. I just follow them religiously. If you are interested, click this link below to access our "Save the Date" form to allow us to contact you to help us determine if you are eligible for an invitation as soon as they are ready. If you have any questions as to whether you qualify for the event, please send me an email. Attendance is limited. The initial response has been quite strong. I think it is likely this conference will sell out, so I suggest you act now and click on the link and give us your email address to notify you when the conference information is ready in a few weeks. https://hedge-fund-conference.com/SAVETHEDATE06.ASPX?M=1

The Yield Curve, Part 9

Back in the fall of 2000 I became somewhat obsessed in my fledgling e-letter with the yield curve. I wrote about it at least every third letter. The yield curve had inverted and the research suggested that it was likely that a recession would follow within four quarters. That meant that it was time to sell stocks and buy bonds. Remember, back then even though the NASDAQ bubble had imploded, the NYSE average was only a few points of its top and the small cap value funds and indexes were doing just fine.

To quickly bring new readers up to speed, there was a NY Fed study done in 1996 that suggested the only reliable predictor of a recession was the yield curve, built on earlier work by Professor Campbell Harvey, now at Duke. It went so for as to quantify the percentage risk of recession depending upon how inverted the yield curve was.

An inverted yield curve happens when long term rates fall below short term rates. The study looked at the 90 day T-bill versus the ten year bond. Essentially, every recession of the modern era has been preceded by an inverted yield curve of some depth and duration.

There have been times of brief inversion which were not followed by a recession. So the Fed researchers looked at a 90 day average and correlated that to the risk of a recession. You can go to the Thoughts from the Frontline archives (December 30, 2005) at http://www.2000wave.com/article.asp?id=mwo123005 to read more about the inverted yield curve. If you are not up to speed on it, you should be. It is important. The Fed paper was written by Arturo Estrella and Frederic S. Mishkin, economists for the New York Federal Reserve Bank and is at http://www.newyorkfed.org/research/current_issues/ci2-7.pdf. Estrella and Mishkin developed a probability table about how likely a recession would be 4 quarters later given a particular level of the yield curve spread. Let's look at that table from the 1996 paper.

The "spread percentage points" in the table above is the 90 day average. Basically, if the spread is 0.46 basis points, there is a 15% probability of a recession four quarters later. The 90 day average on December 30 was 0.52%. Today it is 0.23% and falling. Rapidly. And it is going to fall more. Today we are looking at a 20% chance of recession within four quarters, at least according to this study.

(Caveat: I just noticed that the table says 2% when it should say a 20% chance of recession at a yield curve spread of 22 basis points.)

The current level of spread on the yield has happened several times in the past 40 years and we have not had a recession follow. So why should we pay attention today? Because it is going to get worse.

Most observers suggested we ignore the full-blown yield curve inversions in 2000 as well. I think it was something like 50 out of 50 Blue Chip economists failed to predict the last recession even a few months out. They ignored the yield curve, all finding reasons why "this time it's different."

In a follow-on paper, Estrella documents that each of the previous yield curve recessions since 1978 produced major academic papers telling us why this time it's different. They were all wrong. We will have another spate of papers and economists suggesting that we ignore the curve as well. That is one prediction you can take to the bank.

I remember asking Estrella in 2000 if he thought we would see a recession based on their analysis in the paper. He declined to give a yes or no. (In hindsight, that was an unfair question. How could a Fed staff member be blunt and say there is going to be a recession?) But he did say it would be interesting. I bet he would say the same today.

The Future of Interest Rates

OK, with that table in mind, let's look at where the yield curve may be going. First, let's look at where the yield curve is today. This week the critical 30 day/ten year spread went negative. You can see this chart at http://www.bloomberg.com/markets/rates/index.html. Stick it in your favorites.

There is today a negative spread of 2 basis points, as opposed to a positive 50 basis points less than two months ago.

It is all but a foregone conclusion that the Fed will raise rates at its March meeting. If the ten year stays where it is, we will see a negative 27 basis point spread in the middle of March, which within 90 days would suggest a mid-30% chance of recession.

If the Fed raises again in May to 5%, without the ten year moving up, we would see a 40% chance of recession as the 90 day average would soon be a negative 50 basis points.

I see that hand going up in the back of the class! What would suggest that the ten year will not go up as well? Good question. Let's look at the data. Here is the chart on the ten year rate for the past 2-1/2 years.

Yes, you notice it has been relatively flat. In fact, except for a two month period in the spring of 2004, the ten year is bumping up against its ceiling for the last three years. This has been while the Fed has raised short term rates by 350 basis points and is clearly going to raise them at least 25 if not 50 basis points more. If "everyone" knows this, then a 5% Fed funds rate is not in and of itself going to push the ten year up all that much. Some new event would need to do that. 5% is no longer a surprise.

Why would the Fed purposely invert the yield curve? Because they are looking over their shoulder at inflation. I wrote about the sacrifice ratio a few weeks back. It is one of Bernanke's academic specialties. Basically the idea is how much pain in terms of higher interest rates and presumably lower employment do you suffer today (sacrifice) to avoid an even bigger pain of inflation and worse problems tomorrow?

(You can read more about the sacrifice ratio and Bernanke by going to the archives for the January 13, 2006 issue at http://www.2000wave.com/article.asp?id=mwo011306)

The sacrifice ratio is now high. This arcane number would suggest the Fed is going to go higher than the market now thinks. While there are very sound arguments for stopping where we are today, voiced by Paul McCulley and others, the people making those arguments do not have a vote on the Fed Open Market Committee.

And let's be clear, there are inflationary pressures in the economy. Nowhere is this better illustrated than this letter from my friend Matt Kemp. Let me give you a portion.

"Something is bothering me that I must comment on. Maybe you are fully aware of the situation and think we are still ok. Our business is very liquid and totally debt free but I am very concerned. I am a 3rd generation business owner in manufacturing. (Machining of iron castings, steel bar, forgings etc.) Most components are to a Caterpillar Blueprint and are shipped to Cat plants all over the world. Many parts are precision machined and assembled for Earth Moving Equipment and On Highway Truck Engines. What is bothering me as one of the few left directly in manufacturing is the Hyper Inflation I am seeing. I don't know if you are fully aware of what we are experiencing.

"Some examples. These are increases from 2000.

-All grades of steel bar increase in price from .28 cents a lb. to .80 cents.

-My tier 2 suppliers, the big boys like Grede and Thyssen Krupp Waupaca have passed through total price increases of Well over 20% by part number on thousands of parts for Cat, John Deere, Case etc. For example scrap metal has gone from 150 a ton to 450. Plus the base metals to make the iron.

-My Heat Treaters have instituted 15% gas and energy surcharges as a percentage of the total bill.

-The truck lines have implemented as high as 40% fuel surcharges on the total freight bill.

-Wood spacer boards for packaging finished product have gone from $1.25 to 2.47 per board.

-Cardboard for packaging from .22 cents each to .48 cents.

-Hydraulic oil for all of my machine tools has gone from $4.80 to $7.00 per gallon and I use Thousands of gallons a year.

-Cutting fluid Coolant oil from $7.70 to $11.30 gallon. Use thousands of gallons per year.

-Inserts and cutting tools of all kinds up 40% in price.

-Cleaning supplies, Roll towels, toilet paper, degreasers, paper up 25-40%.

-Utility bills that are 30% higher.

And he concludes with this sour note:

"This is just a sampling. Where does this end? Many cases it is very hard to pass it on. However, and this is the key, When we quote new work the costs are much higher and the piece price comes out much higher. (My competitors are all doing the same thing). All this leads to being less competitive in the Global market place. China will take even more work. When the big slowdown comes everyone will be searching for work but with all there price increases they will have priced themselves out of the market. Then they start buying work to keep cash flow going and many end up out of business. I have seen this too many times over the years. It is going on now."

This is just one anecdotal reason the Fed is worried about inflation. There are others. Unless the economy gets soft in the next few months, which does not now look likely, the Fed is going to keep raising rates.

So, we come to May or June and the yield curve is really negative, on the order of 50-75 basis points. Now, it gets really interesting. Let's look at the 6/50 Rule to get some idea of where long term rates might go in the last half of the year.

The 6/50 Rule

Today I went with my research analyst Keith Black (who is based in Chicago where he is a professor at Illinois Institute of Technology and teaches classes on hedge funds) to look at a hedge fund in Dallas. Good friend and research analyst Ed Easterling of Crestmont Research was there, and at lunch the topic turned to the markets, as it often does when we are together. He asked what I was going to write about today and I went over with him the ideas I presented above. He reminded me of his 6/50 Rule. Then I realized I had to end with that thought.

You can go to www.CrestmontResearch.com, click on interest rates and then scroll to the bottom of the page and click on the 6/50 Rule to see the charts I will briefly discuss. The principles they illustrate are very important to your understanding of bond prices and interest rate moves.

The summary Ed gives is as follows:

"In the past 35 years (with a two-month exception), there has not been a 6-month period during which interest rates did not change at least 50 basis points [somewhere along the curve]. Interest rates are much more volatile than most investors realize. As history demonstrates, more than half of the time, interest rates change by more than 1.5% (and over 25% in percentage terms) over all 6-month periods. This set of charts and statistics (a total of five pages) presents the data..."

OK, let me summarize the charts. First, Ed went to the Fed database and downloaded all interest rates for the last 35 years, from short term to long term. What he found was that:

"Over the past 35 years, interest rates have moved more than 50 basis points (+/- 0.50%) at some point across the yield curve during every subsequent six month period (except following the first two months of 1998). Based upon the history of interest rates, at least one interest rate point along the yield curve can be expected to exceed the upper boundary or lower boundary within the next 6 months (before the end of the year)."

In actuality, more than 82% of the time, the movement was in fact greater than 1% and was more than 1.5% more than 50% of the time!

Boring old bonds are anything but stable. Volatility, thy name is bonds.

Now, the caveat to this is that the movement did not necessarily take place all along the yield curve. It could happen on either short term rates or long term rates (or both). But the research shows that SOMEWHERE rates moved more than a minimum of 50 basis points, either up or down.

The observant reader (of which you are no doubt one - I have no other kind) will note that 50 basis points in 1980 when interest rates were 15% or more was nothing. "So what does that statistic really mean?" you ask.

Let's look at the moves in percentage terms. 65.8% of the time, the move was more than 20%. That would mean a rate of 4% would expect a change of 0.80% almost 2/3's of the time. That is still quite a significant chance for a significant move.

Let's look at what History might tell us about future interest rate moves. If the Fed raises the short end 50 basis points, one would presume they are not going to turn around and start lowering any time soon. There is now an anchor on the short end of the curve. That means the long end of the curve is very likely going to move at least 50 basis points or more!

But which way? If the ten year moves up, then we see mortgage rates clearly above 6.5% and pushing to 7%. That will kill the cash out re-finance business. It will slow consumer spending. It will most certainly not be good for the housing market. In short, it would be at the very least a real slowdown in the economy.

But the US economy is surprisingly strong. Perhaps the Fed feels it would be just a slowdown and a soft landing would be worth putting a stake in the heart of inflation.

The problem is that by the time they (and we) know whether they have gone too far or hit it on the money, we have already arrived. To late to go back. There are no mulligans when it comes to Fed policy. This is the pro circuit. You have to hit it right the first time.

Of course, on the other hand we could see the ten year drop by 50 basis points. Today the ten year is at 4.57% It was only 2.5 years ago that the ten year was at 3.18%. The ten year was at 4% just six months ago. If the economy starts to soften, you might easily see the ten year begin to drop back to 4%. This would of course, have the effect of making the negative yield curve even steeper and the probability of a recession even higher.

This all suggests to me that the Fed funds rates are about where they should be. It takes time for rate hikes to have an effect. While core inflation is at its upper end of the comfort zone, there are signs it may be coming down, the letter mentioned up above notwithstanding. But I do not have a vote and thus rates are likely to rise.

This means the members of the Fed must be willing to purposely invert the yield curve. They must either fear future inflation more than a slowdown or possible recession, or they simply think its different this time. If you believe an inverted yield curve does not mean a recession why let something that has no meaning influence Fed policy? Better to fight inflation. Or at least that is what I think the policy discussion is when they meet late at night in the bar (or wherever Fed governors hang out).

One final thought. Fed Governor Ferguson resigned this week. He was one of the last voices on the Fed which resists targeting inflation, which is what Bernanke has argued the Fed should do. His departure also means that President Bush will have appointed every Fed governor, which is unprecedented.

I am reminded of the line from Indiana Jones and the Last Crusade. Indiana was confronted with a table full of goblets. One of them was the Holy Grail. Drinking from it would bring health and immortality. Drinking from any of the others would bring death. The Grail Knight looked at Jones and said with this gravelly understated voice, "Choose wisely."

Let us hope that fellow Texan Bush has chosen wisely.

Me and My Shadow

I don't want to say I am busy, but my shadow had been complaining about having to keep up. But I have to admit I am (mostly) having a lot of fun. I am setting aside several hours a day to work on my book on where the world is headed, and I find the research fascinating. I am working my way through that pile of books I have near my desk. I am alternately excited and then fearful about the future. It seems there are very few people in the Muddle Through camp when it comes to the future.

I am going to take a vacation when I finish the book. The question is, "Where?" My brother is researching a book called Unending Spring about places around the world which have spring-like weather all year round. He is off to Vietnam to live in the mountains for the next month or so. He independently outsources software development to code jockeys around the world and can work from his computer, so he is off to chase the eternal spring. I am left to look through International Living for my next target spot. You can subscribe for your own copy at http://www.isecureonline.com/Reports/IL/WILVG266/.

Speaking of travel, I should thank the staff at the Riverbank Park Plaza in London. This is the third time I have stayed there and I really like it. It is newly built, beautiful and comfortable modern rooms, very competitively priced and my room had a great view overlooking the Thames, The Parliament and Big Ben across the river. Plus, when I left my dress shoes (rookie!) the concierge found me a pair in my size on a moment's notice on Sunday night. I think it is one of the better travel values I have had. You can click on http://www.riverbankparkplaza.com/. The room view on the home page was the one I had.

It's time to hit the send button. I am off to have dinner with daughters #1 and 2, and maybe a boyfriend or two. I don't know about you, but I find my kids are more fun the older they get. And I get scared thinking about how my business would work without Tiffani here to handle the regulatory details plus a thousand other details. Not to mention a great staff that makes sure things run smooth. Harry will read this letter after I am on the road. Couldn't be half as productive (or sane) without them.

Have a great week and find some time to spend with friends.

Your starting to really think about the future analyst,

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