Yield Spread: 10 Year and 2 Year Treasury Bonds

Basis Points, NBER Recessions in gray



Converted this into recession probabilities, the spread predicts improving conditions throughout the year and into 2009:

Recession Probabilities

12-month ahead forecast, NBER Recessions in gray



Where can one find news to support the 10-2 yield spread story? One hint comes from Calculated Risk, who notes:

This graph indicates the difference between single family starts and new home sales has narrowed recently, possibly indicating: 1) that fewer homes are being built by owners, and 2) that single family starts are now low enough to begin to reduce the inventory of new homes for sales.

The second point caught my eye, especially after seeing that housing starts are approaching their historical lows. Granted, theoretically they could fall to zero, but that’s not exactly a realistic expectation. Housing starts will eventually bottom, and with starts approaching a level that realistically allows for inventory reduction, it is not unreasonable to expect the bottom to come sooner than later. Even arch-bear Nouriel Roubini envisions a time when housing starts will bottom. From the WSJ:

New York University economist Nouriel Roubini expects housing starts to drop to at least 700,000 before hitting bottom, with home prices falling through at least 2009. "We're still in the first few innings" of a recession, said the chairman of research firm Roubini Global Economics.

Given that in March 2008, housing starts stood at 947k, down from a cycle peak of 2.3 million units, we probably aren’t more than a few months away from the bottom, even assuming a worst case Roubini scenario. Reaching a bottom is important in that new residential construction would no longer be a drag on GDP growth; do not underestimate the impact of a flip from subtracting 1+ percentage point of growth each quarter to a flat contribution. Aside from the consumer, incoming data is consistent with an economy scraping along the bottom - Jim Hamilton offers this forecast:

If we eke out a barely positive growth rate for real GDP for 2008:Q1, that along with the anemic 2007:Q4 performance and a sharp drop in 2008:Q2 would probably qualify as a recession.

Hamilton’s forecast of Q1 appears reasonable, but I suspect the expectation of a sharp drop in Q2 is overly pessimistic given that the consumer data should pop temporarily as the tax rebate checks roll in, even if only half those dollars are spent. Also consistent with the borderline recession story are the ISM manufacturing and non-manufacturing indexes:

ISM - Index of Manufacturing Activity

Index, above 50 reflects increasing activity



ISM - Index of Non-Manufacturing Activity

Index, above 50 reflects increasing activity



Just to be clear, while the technical recession may be relatively short lived, I am not optimistic about the other side of this downturn – no V-shaped recovery is in my forecast. Instead, I look for something between the U and the L shapes. My baseline scenario is that housing starts move sideways after bottoming, neither contributing nor subtracting from GDP. The housing sector will likely remain in disarray until prices contract to their historical relationship with incomes. Assuming the mortgage industry returns to historical underwriting conditions, the capital simply will not be available to support prices higher than roughly 3 times local median incomes. I have trouble seeing a way around such a constraint short of continued, substantial taxpayer support that would effectively amount to a policy decision that the average household should be expected to devote 40-50% of its income to housing costs. I really cannot see this as a socially optimal outcome, and I expect that it would be met with a backlash sooner than later.

Similarly, I expect the job market to remain challenged; recall the period of soft job growth though 2004 following after the technical end of the previous recession:

Non-Farm Payroll Growth

Thousands of employees, monthly change



I anticipate the current cycle to be similar. Jobs will continue to be shed in the housing sector as capacity falls in line with a reduced demand. Moreover, these displaced workers will not easily regain employment in expanding sectors such as health care or export industries. Soft job growth and declining access to credit via home equity should keep a lid on consumer spending growth, similar again to the post-2001period:

Real Consumption and Confidence

Spending percentage change Y-o-Y (Red), left

Consumer confidence (Blue) , right



So how does one reconcile the so-so ISM data with the consumer data, the latter of which is more clearly dire? Again, I believe the data reflects an adjustment away from a growth path that depends upon the external imbalance. A portion of the consumer slowdown will be off-shored to foreign producers, and exporters (primarily manufacturers) will benefit from the weaker Dollar. The consequence should be a relatively muted downturn and an expected improvement in the current account deficit:

US Current Account Deficit

Percentage of gross domestic product



The adjustment should yield stark disparities in rates of economic activity across sectors, and this appears to be revealed by the first wave of earnings reports. From the WSJ:

As first-quarter corporate earnings reports begin to roll in, a stark picture is emerging of an economy on two tracks. Banks and companies that sell directly to consumers are grappling with the impact of falling home prices and tightening credit. But many big businesses, especially those that sell to other U.S. companies or to customers abroad, are proving resilient.

Best that this adjustment occurs slowly, considering the enormous pressure on the consumer already evident from the gradual improvements to date. Of course, the slower the pace of the adjustment, the longer as well (again, somewhere between the U and L-shapes), and therein lays the danger for policy. Policymakers will be hard pressed to allow the process continue unabated, as they lack the courage to tell Americans that the country needs to learn to live within its means. Given a growing populist sentiment on the back of stagnating median incomes, I see little but a river of red ink from the Federal government.

Monetary policy should be more circumspect, and financial markets are greenlighting the Fed for an end in the easing cycle at 2% despite tame core-CPI data in February and March. From Across the Curve:

Some participants with whom I converse are troubled by the spectre of inflation. While the report issued today was not ugly ,the surge in commodity prices and agricultural prices reminds investors that there will be no inflation relief in the near term. The best bet is that the headline number will only worsen as we go forward. So some traders think that the process has begun by which the market adjusts to the Federal Reserve signalling that the ease cycle is over or is nearly done. That would not bode well for the 2 year note and would precipitate higher yields in that sector.

I would argue that monetary policy is already too accommodative given that the fear of deflation appears misplaced. From Philadelphia Fed President Charles Plosser:

Taking expected inflation into account, the level of the federal funds rate in real terms — what economists call the real rate of interest — is now negative. The last time the level of real interest rates was this low was in 2003-2004. But that was a different time with a different concern — deflation — and monetary policy was intentionally seeking to prevent prices from falling. Recently, we have had reason to be worried about rising inflation, not declining prices. Thus, comparing the nominal funds rate today with the stance of policy in 2003–2004 is like comparing apples and oranges.

Normally, I would not give much credence to Plosser; he has been out of step with the FOMC through the current cycle. But in the same speech he emphasizes that monetary policy alone cannot solve the current challenges, a realization also made by Governor Kevin Warsh

Fed policy--both with respect to liquidity tools and monetary policy--is partially offsetting the consequences of the liquidity and credit pullback on real activity. But we must be careful to not ask policy to do more than it is rightly capable of accomplishing. The problems afflicting our financial markets are indeed long-in-the-making. Correspondingly, the curative process is unlikely to be swift or smooth. Time is an oft-forgotten, yet equally essential, tool of our policy response.

Warsh also acknowledges the impact of surging commodity prices on inflation:

Consistent with our dual mandate of promoting maximum employment and stable prices, we also need to be alert to risks to price stability. Increases in food and energy prices have pushed up overall consumer prices and are putting upward pressure on core inflation and inflation expectations. We will continue to monitor the inflation situation closely. And, more broadly, in my view, as financial intermediation channels reset, monetary policy will become still more efficacious.

Even arch-dove San Francisco Fed President Janet Yellen cannot ignore the impact of inflation:

The factors weighing down consumer spending go beyond the effects of the credit crunch and the falling house prices. Consumers also face constraints due to the declines in the stock market, which have diminished their wealth. Furthermore, energy, food, and other commodity prices have risen sharply in recent years, essentially “taxing” their incomes. Finally, and very importantly, labor markets have weakened.

The recent wave of commodity price increases I think was undoubtedly exacerbated by the Fed policy of recent months – it takes a leap of faith to ignore the run that was ignited when the Fed cut the discount rate last August. My concern is that we have now passed the point of no return; even if the Fed stops cutting rates, the expectation of stronger growth will drive further gains in commodity prices. From Bloomberg:

Crude oil and gasoline climbed to records in New York as better-than-expected earnings results signaled a strengthening economy that may boost demand. U.S. stocks rallied, capping the best week since February for the Standard & Poor's 500 Index, following earnings reports from companies such as Google Inc. and Caterpillar Inc. that exceeded analyst estimates. Refineries operated at 81.4 percent of capacity last week, the Energy Department reported. ''The real gloomy scenario has been sort of ameliorated with some of these very positive earnings and the indication that the worst is behind us,'' said John Kilduff, vice president of risk management at MF Global Ltd. in New York. ''There will be an uptick in energy demand with the renewed economic outlook for the second half of the year in particular.''

I tend to agree with George Soros; we are still in the early stages of the commodity price boom, and that boom will not come to a conclusion until the inflation outlook is uncomfortable enough that the Fed reverses policy. In the near term, that looks very unlikely. The Fed is still counting on weak job growth to keep core prices under control, but that is an increasingly fragile forecast. From the most recent Beige Book:

Business contacts across all Districts continued to report increases in input costs and output prices. In particular, price increases were consistently reported for food products, fuel and energy products, and many raw materials. More specifically, increases in the price of chemicals, metals, plastics and other petroleum-based products were commonly cited. Most manufacturers have or are planning to increase prices in response to rising input costs, while the response of service firms has been more mixed, in part due to differences in competitive pressures. On balance, input costs have risen more rapidly than output prices, putting pressure on margins for many firms. Most Districts reported little change in retail price inflation, though Richmond and San Francisco noted some moderation.

My concern here is that firms will jump at the first chance to drive through price increases, and that chance will be in the next two quarters as the tax rebates provides a boost to consumer spending. If so, the Fed will be well behind the inflation curve. Although Fed officials believe they can quickly unwind the policy decisions of the last six months, I think it is easier said than done given anticipated weak job growth and still fragile financial markets.

Bottom Line: I suspect the cessation of rate cuts is near at hand. The Fed will likely pull the trigger on another 25bp at the next FOMC meeting, and send a signal that they intend to pause soon. I believe they could pause now, but see this as unlikely given their tendency toward dovishness of recent months. Another 25bp in June is not out of the question, but I think unlikely as well. It will soon be time to turn our attention to timing the next tightening cycle. Expected job market/housing weakness argues for an extended period of low rates similar to the last cycle; continued strength in commodity prices argues for a more rapid reversal of recent policy. I believe that a rapid reversal of policy will be politically difficult for the Fed given that Congress will tend toward resisting any protracted structural adjustment that is painful for US households.