Fear the Inverted Yield Curve?

Is the U.S. economy in for a recession this year? Or next year, perhaps? Most economists say it’s not likely, arguing the U.S. economy is on solid ground. Still, they acknowledge the potential appearance of some very significant banana peels—high energy prices and a cooling housing market, to name a couple—that could derail U.S. economic growth.

Is the U.S. economy in for a recession this year? Or next year, perhaps? Most economists say it’s not likely, arguing the U.S. economy is on solid ground. Still, they acknowledge the potential appearance of some very significant banana peels—high energy prices and a cooling housing market, to name a couple—that could derail U.S. economic growth.

Frank Fernandez, the SIA’s chief economist, a self-described pessimist on most “good” news, finds himself agreeing with his colleagues on talk of recession—that is, that there won’t be one. And when he meets on March 1 with more than a dozen other well-known macroeconomists that make up the New York State Economic and Revenue Consensus Forecasting Conference, he expects there to be few, if any, doomsayers.

“So far, nobody in this group is forecasting a recession,” he says. “A slowdown? Yes, probably the same growth as last year or possibly down to trend,” he says. Fernandez expects real GDP growth to decline to 2.6 percent in 2006, down from 3.1 percent in 2005, a needed slowdown he calls a “gradual slump.” Unless, of course, one of those banana peels—an oil-price spike or housing-price crash—gets in the way and turns it into a fall; but until one of those things is a certainty, he says, with first-quarter growth running near 3 percent, he remains optimistic.

Stuart Freeman, A.G. Edwards’ chief equity strategist, says the Fed should tread cautiously in its meetings on March 28 and May 10, lest it upset an orderly and needed economic slowdown. He writes in a February research update that previous rate increases need time—a year by his estimate—to settle in. Like Fernandez, he says year-to-date data show the economy is slowing and inflationary pressure is minimal; therefore, rate hikes must stop “very soon or the probability of a below-trend slowdown in growth (or a recession) will noticeably increase.”

George Soros, the legendary hedge fund manager who most famously “broke” the Bank of England by speculating against the pound in 1992, agrees but specifically predicts a 2007 recession if the Fed doesn’t chill out. Speaking at a conference in Singapore in January, Soros warned that the U.S. economy could crash in 2007 if housing markets cool off and the Fed has raised rates too high. “Almost inevitably, they have got to overshoot because they can’t stop until the economy shows signs of a slowdown,” he said. By that time, he said, it may be too late.

Since his comments, the Fed raised rates on Jan. 31, but only 0.25 point to 4.5 percent, not to 4.75 percent as Soros expected. But the new Fed maestro, Bernard Bernanke, will be given the opportunity to raise them further at the next Fed meetings in March and May.

Bond folks expect he will, given the way he brushed aside a historically accurate predictor of recessions—the inverted yield curve. Traditionally, when short-term interest rates are higher than long-term interest rates, as they are now, it signals that the economy has slowed down, or could be headed towards recession. The last two times the yield curve inverted were 2000, before the last recession, and in 1998. But according to economists, other than 1998, every recession has been accompanied by an inverted yield curve. Still, Bernanke insisted in the Feb. 15 meeting with Congress that this time it doesn’t signal a slowdown. He says cash-rich foreign investors as well as U.S. pensions and insurance companies are willing to accept low long-term yields in exchange for the safety of U.S. assets. He also said that previous inversions came when overall rates were much higher than they are today.

What do advisors think of all this? Mike Delgass, a managing director of Sontag Advisory, an independent RIA in Westport, Conn., says he’s no macroeconomic expert but worries that uncertainty around Bernanke’s decisions at the next meetings could cause a downward correction in equities. “The first part of Greenspan’s chairmanship wasn’t good for equities,” Delgass says, partly due to uncertainty about his tendencies. “But when we had more certainty of rate rises from the Fed you could be sure that rates were already priced into the markets,” he says. For that reason, “it’s not the March meeting I’m worried about, it’s the next couple after that worry me.” That said, Delgass is mildly optimistic about domestic equities in 2006. And while he’s still overweighted in international and emerging markets, he’s still hopeful for a large-cap growth resurgence.

Eric Park of Steamboat Financial Group, an LPL affiliate in Washington, Mo., expects rates to go up in March but is betting there’s a decent chance the Fed will stop there. In anticipation of the hikes he says he’s laddering CDs, bonds and other fixed income for clients, lengthening maturity dates. “Corporate earnings have been accelerating for 15 quarters,” says Park, who, despite a few big “ifs,” also remains positive for the year: “If we stop raising interest rates and earnings continue to grow—albeit slower, in the single digits—and if there’s no oil spike we have a good chance of having a really good year,” he says. But only if.

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