Wednesday, September 23, 2015

Why a recession is very unlikely

Here are four charts that suggest that a recession is quite unlikely, at least for the foreseeable future.

As the chart above shows, the past three recessions have been preceded by a significant rise in 2-yr swap spreads. Swap spreads, as I explain here, are essentially barometers of systemic risk. When they are as low as they are today—which is quite low, in fact—they tell us that financial markets are extremely liquid and it is very easy for those who are nervous to lay off risk on others. It's almost the opposite of the "don't shout fire in a crowded theater" phenomenon, because those who these days are worried and want to get out have almost no problem doing so. The problems happen when everyone wants to get out at once, which is what leads to high swap spreads. If everyone is feeling scared, if everyone is worried about the ability of others to survive, if money is scarce, then the underlying fundamentals have deteriorated significantly and there is something very wrong out there. Today, swap spreads are telling us that the economic and financial fundamentals are very sound; thus there is a very low probability of a recession.

As the chart above shows, the past 8 recessions have been preceded by two very important developments in the bond market: high and rising real short-term interest rates (red line) and flat to negatively-sloped yield curves (blue line). High real short-term interest rates are the Fed's main tool for slowing down an "overheated" economy and reducing inflation. High real rates make borrowing expensive and increase the demand for money (remember: inflation happens when the supply of money exceeds the demand for money—taking steps to increase the demand for money thus reduces inflation pressures). When the Treasury yield curve becomes flat or inverted (i.e., when short-term interest rates approach and/or exceed long-term interest rates) this is the bond market's way of saying that monetary policy is so tight that it is unlikely to remain so for much longer. When long-term interest rates are higher than short-term rates, the bond market is effectively forecasting that short-term rates will be declining in the future because the Fed will sooner or later need to "help" the economy by reducing rates. A positively-sloped yield curve, on the other hand, is the bond market's way of saying that short-term interest rates are unlikely to remain low and are very likely to rise in the future because the Fed will at some point need to "withdraw the punch bowl."

In short, high real interest rates and a flat or inverted yield curve are very reliable indicators that monetary policy is so tight that it is threatening the health of the economy. That is manifestly NOT the case today. It would likely take years for these two indicators to move into the red zone.

It's common knowledge—or at least it should be—that the Fed manages monetary policy by targeting the overnight Fed funds rate. Actually, that's not exactly the case these days, because the most important tool the Fed now has is the interest rate it pays on excess reserves (IOER). But in practice they both mean the same thing: the Fed can cause short-term rates to rise or fall at will. However—and this is not so common knowledge—what the Fed is really trying to do by raising or lowering short-term interest rates is to change the level of inflation-adjusted short-term rates. If inflation is 10% and short-term rates are 5%, the monetary policy is extremely loose; but if inflation is 2% and short-term rates are 6%, then policy is extremely tight.

While the Fed can influence short-term rates directly, it has much less control over longer-term interest rates, which are set by the bond market depending on the market's expectations for inflation and real economic growth.

So the best way to understand Fed policy is to realize that the Fed controls the front end of the real yield curve, but not the back end. When the real yield curve is positively-sloped, the Fed is easy because the market figures that they will almost certainly have to raise real rates in the future. When it is flat or negatively-sloped the Fed is tight, because the market senses that the Fed will almost certainly have to lower rates in the future.

The chart above shows us two points on the real yield curve: the real Fed funds (overnight) rate and the real rate on 5-yr TIPS. Note that the red line exceeded the blue line before each of the past two recessions—which means that the real yield curve was negatively sloped prior to each recession. This chart thus reinforces the message of the preceding chart, since both the real and nominal yield curves prior to the past two recessions were negatively sloped. Today that is manifestly not the case. Real short-term rates are lower than real intermediate-term rates. The market, in other words, fully expects the Fed to increase rates going forward. Higher interest rates are a given, not something to worry about.

The chart above shows the level of real GDP on a semi-log scale, so that a constant slope is equal to a constant rate of growth (in this case 3.1% per year). The current recovery is unique in modern history, because the economy has for six years failed to recover to its prior trend growth rate. There is, in other words, a huge "output gap" which I estimate to be about 15%, or roughly $2.8 trillion per year in income that has gone missing. It's the weakest recovery ever.

What this means is that there is an enormous supply of unused capacity in the economy today. Maybe 5 or possibly as much as 10 million people who could be working but for whatever reason are not. Factories that have lots of idle capacity. Stores and shopping centers that have unused space. It's easier for the economy to slow down when there are lots of capacity constraints, than when—as is the case today—there is plenty of capacity. Capacity constraints tend to be associated with expensive prices for capacity, and when the Fed makes money scarce then it becomes harder for businesses to pay for labor, materials, and infrastructure. Capacity constraints plus tight money equal recession risk.

Today, money is abundant and resources are abundant. Even energy is abundant, because its price has fallen by over 50% in the past year or so. Corporate profits are near record highs, the supply of labor is virtually unconstrained, energy is suddenly cheap, and productive capacity is relatively abundant. This adds up to a lot of room for maneuver and very little reason for the economic engine of growth to shut down.


Benjamin Cole said...

I will be happy if I never see another recession again. I would be even happier to see very robust economic growth.

Cut FICA taxes and ramp the Fed up to full tilt boogie boom times in Fat City.

PS 10 million more who could be employed?

There are 12 million people alone who collect "disability" from SSDI or the VA. We have plenty of workers....

Roy said...


You seem to be quite knowledgeable about LatAm, would be great if you could write your thoughts about that area in general (read what you wrote about Argentina before). Do you reckon Chile will be able to survive (as in, not default) if the countries around it go into recessions and possible defaults?

With the currencies crash over there we have started to fantasize about buying a place by the ocean...


marcusbalbus said...

don't worry, your charts will hold off the recession.

Benjamin Cole said...

Speaking of leading indicators---

The above series I was tipped to by The Speculative Investor, a gold-Austrian guy. Sure does seem to lead a recession...and does not point to recession now...

Hans said...

No recession would mean the continuation of FedZero or Fedonimics.

Growth rates (real GNP) will deteriorate for the lack of structural

PittsburghDog said...


Please in your next post can you identify any activities besides housing starts that are positive. I fear that your financial indicators may be lagging and not yet picking up what is going on in the economy. ISM Non-Manufacturing Index (down), Philly Fed Manufacturing Activity Index (down), New York State factory activity (down), etc. I worry the wall of worry that we've been climbing is starting to develop some instability.

Economically we don't seem to lack the raw materials (Labor, capacity, financing, etc.) necessary for our economy to move forward. Companies seem to lack the faith to invest in the economy. I fear we are in early stages of a recession driven by deflationary fears, more than an inflationary reality.

BlueDun said...

Thanks, Marcusbalbus. I look forward to your considered explanation and opinions. You have provided such enlightening content to these pages.

Johnny Bee Dawg said...

Ballbust in da HOUSE!!

Scott Grannis said...

Re: Gross Private Domestic Investment. Indeed it does seem to be a decent leading indicator of recessions (investment goes flat or down prior to a recession), and at least through June this shows no sign of any meaningful slowdown. But investment by this measure has been relatively sluggish compared to other recoveries. One more example of why this has been a weak recovery: anemic investment. HT to Benjamin for linking to this.

Scott Grannis said...

Re: Chile. Chile, like other countries whose economies are dominated by commodities, is in a tough spot given the weakness of copper prices. But the country is not overly indebted and the government has taken steps over the years to minimize the economy's exposure to fluctuating copper prices. Unfortunately, fiscal policy has shifted to the left in recent years, so growth is not as strong as it could be, and inflation has been picking up (now >5%). I don't think the economy is out of the woods yet, and it seems likely that the peso will decline further. But I don't see a serious problem developing there. Most likely, another year or so of very slow growth or a mild recession. Chile could be doing a lot better, but it is in better shape than Argentina.

Matthew Grech said...

Marcusbalbus: I'm more than a little interested in the negative viewpoint as I believe there are at least several negative super trends at work in the US/world. I really would be curious to see the support you have for your positions.

If you think we're all a bunch of dolts - in my case, I wouldn't even push back hard! - please state why. I would sincerely be interested.

Scott Grannis said...

Re: positive indicators other than housing starts: Auto sales are rising at a 3-4% rate. The manufacturing ISMs are not particularly strong, but do point to continued growth (i.e., readings above 47). The non-manufacturing ISMs are quite strong (high 50s and 60s). Capital goods orders are up in the past 3 months, but not particularly strong. C&I Loans have been growing at 10-12% for years. New home sales are increasing nicely. Commercial real estate values are rising 12% per year. Unemployment claims are very low and still declining. Private domestic investment is up a healthy 5-6% in the past year. Leading Indicators are still rising. Federal revenues are rising at an 8% annual rate, proof that incomes, jobs and profits are still rising. Rail shipments, truck tonnage and vehicle miles are all rising at a 3-4% rate, proof that the economy continues to grow. Retail sales are up at a 7% pace in the past six months.

Scott Grannis said...

More positive indicators: residential construction is up 16% in the past year, nonresidential construction is up almost 13%.

Scott Grannis said...

Re: Fed, QE, and Operation Twist

I have made quite a number of posts on this subject over the years, and I'd recommend this one in particular:

In short, I don't see evidence to support the claim that the Fed is able to manipulate longer-term interest rates.

Oeconomicus said...

Great post Scott. I really enjoyed this one. Especially the interest rates and yield curve explanation.

I study my econ texts from time to time to brush up on interest rate theory.

My last blue book test in Money and Banking a long time ago included a question on what the Fed needed to do to influence short term interest rates fro a desired outcome. We used charts to show what they needed to do to get the short term rate to x.

But now that they pay interest on excess reserves I've wondered how that affects those charts/models. It seems open market operations to control the Fed Funds rate is still not exact (they can't hit it perfectly). But when paying interest on excess reserves they can instantly state that rate with greater control.

Would you elaborate on the Fed Funds tool vs. the IOER tool?


Thinking Hard said...

Any comment on the shadow FFR calculated by the FRB of Atlanta?

Lawyer in NJ said...


I saw this note at Convergex:

"The 10 – 2 year spread is flashing yellow at the moment, with a 145 basis point differential. At the beginning of 2014, it was over 250 basis points. At the start of 2015, that had collapsed to 135 basis points. That decline turned out to be a remarkably good indicator of both the tepid growth we’ve seen in the U.S. and the deflationary pressures of lower energy prices. Score one for the Treasury yield curve as an easy-to-use economic forecaster."

What are the range of healthy and unhealthy spreads?


Scott Grannis said...

[Would you elaborate on the Fed Funds tool vs. the IOER tool?]

Before the Fed decided to pay interest on reserves (IOER), the Open Market desk added or subtracted to the supply of bank reserves (by buying or selling Treasuries) with the aim of targeting the Fed funds rate (the rate at which banks lent each other the reserves they didn't need). If the actual rate of FFs exceeded the target rate, then obviously there was a shortage of reserves and so the Open Market desk would buy bonds and inject reserves, and that would bring down the FFs rate.

Under the new regime, bank reserves are in abundant supply for the foreseeable future. So now the Fed will manage short-term rates by directly setting the rate it pays on reserves. They will attempt to make this rate impact all short-term or overnight rates by allowing non banks (e.g., mutual and money market funds) to participate in this same rate via a transaction called reverse repos. This will effectively allow banks and non-banks to lend money to the Fed at the same rate as the Fed is paying on reserves. Today only banks can lend money to the Fed (by holding excess reserves) and receive an interest rate of 0.25%. Going forward, many others will be able to do the same by entering into reverse repo transactions with the Fed.

The Fed has been experimenting with this method for some time already, and there is no reason to think that it cannot work. In theory, there shouldn't be much of a difference between the old regime and the new regime.

When the Fed raises the IOER, it makes it more attractive for banks to hold excess reserves and less attractive to use their excess reserves to collateralize new lending to the private sector. In this manner the Fed hopes to keep the huge amount of excess reserves from turning into an even greater amount of new lending, since that might well result in "too much money chasing too few goods."

Scott Grannis said...

[Any comment on the shadow FFR calculated by the FRB of Atlanta?]

I don't see much difference between the shadow rate and the real Fed funds rate that I've shown in my charts. Both tell us that monetary policy is very accommodative.

Scott Grannis said...

Re: the 2-10 Treasury spread.

Since 1980, this spread has averaged a little over 100 bps; today it is 145. The red line in the second chart of this post gives you a very close approximation of the 2-10 spread. During periods of economic growth, the spread tends to range from 20 bps to as much as 280 bps. The current level is perfectly consistent with ongoing economic growth.

The time to worry is when the spread approaches zero and/or becomes negative, as I've noted in the post.

jpicerno said...

A broad set of indicators support's Scott's view that a recession is unlikely. I track 14 US macro indicators and 12 are trending positive on a year-over-year basis through August--confirmed by today's release of the Chicago Fed Nat'l Activity Index's 3mo avg. The two exceptions on my radar: real monetary base (M0) and the corporate bond spread (BAA-AAA). I'm a bit worried about the recent negative turn in YoY M0, but so far the real economy is still holding up. Here's a look at the numbers via my blog:

marcusbalbus said...

when you don't know you're the force-fed foie gras goose or the Thanksgiving turkey the day before that day, better to leave the illusion as it is. go long my friends.

Lawyer in NJ said...

Thanks, Scott.

honestcreditguy said...

Auto Sales are at or near their peak as the subprime flow and tiered rates have pretty much run their course. Flooring is great for the dealers but inventory on hand is rising with dealers seeing vehicles stay longer on the lot.

Auto was greatly helped by govt. take over of GMAC, renamed to Ally and able to borrow from the fed to jump start subprime lending back in 2010...28% of vehicles sold quarter were to subprime buyers, this will begin to eat into yield via credit quality..

the peak is near or here

Benjamin Cole said...

FYI from Bloomberg:

Bonds Show Inflation Outlook Falling to Lowest Level Since 2009
Daniel Kruger
September 24, 2015 — 11:05 PM WIB

Gauges near levels not `seen outside of times of crisis'
Traders await speech by Fed Chair Yellen on Thursday

The bond market’s inflation outlook for the next 10 years touched the lowest since May 2009, raising questions about the Federal Reserve’s ability to increase interest rates this year.

The 10-year break-even rate, a bond-market measure derived from the yield difference between Treasuries and inflation-linked bonds, showed consumer prices rising at an average pace of 1.48 percent during the next 10 years, well below the Fed’s target of 2 percent. The inflation measure preferred by Fed officials last reached that level in April 2012.

“You’re getting close to levels you haven’t seen outside of times of crisis,” said Aaron Kohli, a fixed-income strategist at Bank of Montreal, one of 22 primary dealers that trade with the central bank. “The market is becoming a lot more pessimistic about the direction of inflation.”
The economy and the bond market have resisted policy makers’ efforts to stoke expectations for higher prices. Instead a slowdown in global growth has fueled a slump in commodities and led the Fed to mention risks posed to U.S. output by reduced growth rates overseas, particularly in China, in its most recent policy statement.


Of course, the Fed says the right inflation gauge is the PCE deflator, which runs about 35 basis points lower than the CPI. So, the market is saying by the Fed's inflation gauge we see 1.15% inflation for next 10 years. That is well below the Fed's 2% IT, which the Fed says is a target, not a ceiling. (The Bloomberg reporter made a mistake in identifying the Fed's 2% target as being on the CPI).

I do wonder---how is it possible the Fed has had a "super-easy hyper-accommodative monetary policy" for seven years straight, yet inflation is dropping to record lows?

Do readers realize these rates of inflation are about one-third those that prevailed during the Reagan Administration's best years?

In recent times, every time central banks tighten up, they have to suddenly reverse course and go back to what is perceived as "stimulus." I think the central banks are fighting yesteryear's wars.

Better now to accept quantitative easing as conventional policy, as has the Bank of Japan.

It is going to take manyy years of robust growth and prosperity to get back to 2% inflation (as an average on the PCE) and we will have to pay down serious chunks of the national debt through QE, but I think we have to show the steel to get there.

Lawyer in NJ said...

Many years, or a significant geopolitical flareup in the Middle East...

wslome said...
This comment has been removed by the author.
wslome said...


Love your posts as always. Out of curiosity, if the U.S. was able to narrow your described "output gap," how much lower do you think the unemployment rate could go?

Related to that question, do you think the current 5.1% unemployment rate is overstating the tightness of labor due to so-called "under-employed" part-time workers? There has been lots of Fed talk of nearing "full employment." Your thoughts would be appreciated...


Scott Grannis said...

wslome: The unemployment rate today is relatively low, primarily because about 10 million people have removed themselves from the labor force (where labor force = those working or looking for work). Presumably, a better set of policies (lower marginal tax rates, reduced regulatory burdens, and tougher eligibility standards for welfare, etc.) would cause a good portion of those people who have dropped out to re-enter the workforce. If they did that all at once it would cause the unemployment rate to soar, of course. But if they did it gradually as jobs also increased, then maybe the unemployment rate would only go up a little and then stay steady for awhile before eventually declining further as the additions to the workforce were hired.

So I don't think it's the case that we are at or close to full employment. I think the economy has lots of untapped potential that could be tapped with a better policy environment. Under-employed people are another problem that could be fixed with better policies.

Perhaps it is the case that the labor market is relatively tight currently, but I think that's mainly because a lot of people are on the sidelines (I'm one of them). Better policies could change that dramatically, just as better policies could result in more investment and more hiring.