The Treasury yield curve continues to flatten, which is widely viewed as a warning sign for the economy. The 10-year/2-year spread fell to 59 basis points on Tuesday (Nov. 21), the lowest in a decade. But the US economic profile looks solid. The mixed messages have more than a few analysts and investors scratching their heads. For some perspective, The Capital Spectator chatted with Bob Dieli, an economist at RDLB, Inc., a boutique consultancy that publishes business-cycle analysis at www.NoSpinForecast.com.
The Treasury yield curve has been flattening this year. History suggests that’s a warning sign for the economy. Yet a number of indicators show that business-cycle risk is quite low. The Chicago Fed National Activity Index for October, for instance, points to solid growth. Is the yield curve broken as a business-cycle indicator?
No. I think its value as a leading indicator is still quite high. But it has a record of giving false signals — the Long Term Capital Management episode, among others, for example. [The 10-year/2-year spread briefly inverted in mid-1998 but the next recession was still three years in the future.] What I am more concerned about is whether the current level of interest rates is accurately measuring the amount of total risk that investors are taking on. Personally, I don’t think that 2.40% is the right level of interest to receive for lending my money to the government for 10 years. The flattening of the curve is an important piece of information, but is not the only piece of information that one should look at in assessing recession risk.
What indicators are at the top of your list in search of early warning signs for recession?
The Enhanced Aggregate Spread (EAS)1 and its four components top the list. The EAS is my contribution to business-cycle research. In addition, I have several employment series that I follow closely and several transportation sector series that I monitor. I use a combination of indicators as I have yet to find one that’s perfectly reliable as a sole indicator of a business-cycle turning point. By the way, you need tools that forecast the ends of recessions as much as you do those that forecast the starts of recessions.
Are US recessions inevitable? Some countries seem to have avoided them entirely for decades. Australia, for instance, has reportedly avoided a formal downturn for the last 25 years. Is there something about the US economy that makes recessions inevitable at some point?
Because I think that nothing grows to the sky, I have to conclude that at some point we will experience a period of negative growth. That said, I would add that all recessions are unique and we should not try to forecast what the next recession will look like until we have had a chance to assess what its antecedents are. So, yes, I think that we will have another recession at some time in the future. And, since I don’t know enough about Australia to assess their claim, I would have to guess that their definition of a “formal downturn” is quite specific. I do recall reading that their economy has gone through some “rough times” over the past 25 years.
If there is another US recession at some point, do you expect that the Federal Reserve’s monetary policy will be a key factor in triggering a new downturn?
Yes. There are no recessions on record that don’t have the Fed’s palm prints on their backs. Recessions are the result of our intrinsic inability to grow to the sky plus the restraint applied by the Fed. Your question implies the usual Fed tightening. My concerns include the Fed being late to react to financial system distress. One of the reasons why we had the problems of 2008 and 2009 was the Fed being too late to intervene with Bear Stearns, AIG and Lehman. All of those firms should have been more closely monitored. There will be more than interest rates involved in figuring out how tight monetary policy will be over the next several years.
How should we think about the Fed’s unusual monetary policy post-2008 as it relates to the business cycle? Is the central bank’s policy raising or lowering macro risk in your view?
It is macro risk with a capital M. Not only does the level and trend of interest rates affect current activity, the fact that rates are rising or falling affects the way that economic data are interpreted and financial plans are made. The last two Fed chairs have been more circumspect in their management of the policy process than their predecessors. As a result, I think the folks who are new to the markets don’t fully appreciate the level of anxiety that a more forceful Fed chair can bring about.
Over the past several years we have had flights to quality that have severely distorted the pricing of risk. Were the Fed to do something that provoked another such episode, their ability to be the arbiter of the level of interest rates would be compromised.
1 The Enhanced Aggregate Spread (EAS) is the combination of the Enhanced Financial Spread (EFS) and the Enhanced Real Spread [ERS]:
EFS = Yield on 10 Year Treasury Note – Effective Fed Funds Rate
ERS = Year-over-year % change in All Items Consumer Price Index – short-term unemployment rate
EAS = EFS – ERS