Recession Risk – Easy Pod: A Little Less Worry About 2012 (Jan 18, 2012)

Recession Risk – Easy Pod

For a “Quick ‘n Easy” read, just review the labeled white boxes, then skip to my “Easy Take” summary at the end.  You can review any charts/graphs afterward.  I want to make sure no one is intimidated by the length of my posts, even though I’m trying to making them easy …

I’m continuing a feature I’m calling “Easy Pod” – a collection of indicators that help portray the current status of something.  In this post, that something is the risk that the U.S. economy will enter a recession in the near future.

(This next section is my usual intro to what a recession is – you can skip straight to below the first line to start reading the actual content.)

Quick ‘n Easy “Recession” refers to a situation where economic activity is declining.  In a recession, we see a loss of jobs, lower spending by consumers and businesses as well as a decline in pretty much every aspect of the economy.  Stock markets decline and house prices likely drop, too.  It can be a vicious cycle before it reverses itself and lets the economy resume growth once again.  Recessions can be deep and last a long time, or they can be mild and brief.  While some like to define it as a negative GDP growth rate for two quarters in a row, the official determination is made by a group called the National Bureau of Economic Research.

Surely you’ve heard the word “recession” thrown around in many of the discussions you’ve read about the economy.  Let’s first review quickly what a recession is and why it matters.

From Merriam-Webster Dictionary:

Recession = a period of reduced economic activity

The most commonly accepted way of measuring economic activity is to examine Gross Domestic Product (GDP).  I discussed what the GDP is in this post.  But a very quick review is that the GDP attempts to measure the total value of all economic activity.  Anything someone is willing to pay for would typically go into GDP.  So, it’s no surprise that one of the easiest ways to define a recession would involve a GDP that goes down.

Many people define a recession as “two consecutive quarters of declining GDP.”  That’s six months of an economy that is basically shrinking.  That’s the quick and dirty method.  But the “official” determination of when the U.S. economy is in recession comes from a group called the National Bureau of Economic Research (NBER).  These folks take a look at all kinds of data, not just GDP.  And they make the determination of when the economy is contracting or expanding.  They often make these determinations many months or perhaps years after the fact.  But it’s considered a more accurate assessment than the simple rule of two quarters of declining GDP.

Why do recessions matter?  Well, you could argue that technically it doesn’t matter whether the economy is growing at 0.001% rate or contracting at a -0.001% rate.  Those two are virtually identical, yet the former could conceivably be the determining factor for being in a recession versus not.  I think the basic idea here is that we want our economy to grow.  It has to grow to support the growing population.  New people need new jobs and new houses.  We can’t have those things if the economy is shrinking.  And while the normal cycles of the economy can lead to brief, temporary periods of contraction (shrinking), we want to avoid prolonged ones.  Thus, the term “recession” refers to a more significant period of contraction.

Determining whether we are in a recession now or that we were in a recession previously is all fine and dandy, but what people like you and me really want to know is whether we are going to be in a recession in the near future.  And for that, there are some helpful tools.  In this “Easy Pod” I will take a look at a few different estimates of the risk of the U.S. economy entering a recession.

For a quick read of this post, just read all the sections highlighted in yellow, plus review the labeled white boxes, and finish off with the “Easy Take” conclusion.

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Method #1: Yield Spreads and Credit Spreads

Quick ‘n Easy We can compare the risk people are willing to take on certain investments versus the basically risk-free investment of giving loans to the U.S. Government.  The difference in interest earned on these various kinds of investments can often help predict an impending economic slowdown.  Right now, this kind of analysis doesn’t seem to be showing a super dangerous red flag.  The fact that risky bonds (“junk” bonds) are paying a higher interest rate than safe ones (higher than usual) is worrisome though.  IMPORTANT: Interest rates have been set so low (basically zero) by the Federal Reserve, that many believe looking at spreads like these are worthless in measuring risk of recession.

Basic Concept: U.S. Treasuries (loans people make to the U.S. Government so it can fund its operations) are considered the safest investment, essentially risk free.  That means you usually get some of the lowest interest paid to you (yield) on these investments – remember, less risk equals less reward.  If you compare the interest rate on other kinds of loans, like corporate bonds (loans that people make to companies so they can fund their operations), to the interest rate of Treasuries, you can get a sense for how risky the other investment really is.  That difference in interest rates is called a “spread.”  Similarly, if you look at the yield on a longer-term Treasury versus a shorter-term one, you can see how much riskier the longer-term loan really is.

Federal Reserve Bank of New York

One of the reasonably good predictors for recessions has been the difference between the yield on 10-year Treasury notes and 3-month Treasury bills.  Generally speaking, when you lend someone money for a longer period of time, you expect to be paid interest at a higher rate, because there are greater risks that the money will not be returned to you, and you likely had other great things you could have done with that money.  Thus, it makes sense that the yield on 10-year Treasuries should be higher than 3-month Treasuries.  But how much more is a pretty good indicator for what is coming up in the economy.

When times are starting to get tough, people start worrying even about short-term loans to the government, and so the difference between these two yields gets less and less.  If it flip-flops and the yield is higher on 3-month than on 10-year, it’s a really good bet that a recession is around the corner (probably 9 months or so later).

The Federal Reserve Bank of New York translates the “spread” (difference) between the 10-year and 3-month Treasury into a probability of recession in the upcoming 12 months.

According to the Federal Reserve Bank of New York, the probability that the U.S. economy will be in recession in December 2012 is only 3.80% – up from a 3.60% chance of recession in November 2012.

Political Calculations Blog

Similar to the way the Federal Reserve Bank of New York makes its calculations, the folks at the Political Calculations Blog use the 10-year and 3-month Treasuries spread.  They actually use the average of that spread over the last month, but then they add a twist.  They also look at the average Federal Funds Rate over the last month.

The Federal Funds Rate is basically the interest rate that banks charge each other for overnight loans.  Generally, when this rate is high, there are fewer loans being made throughout the economy because almost every interest rate is affected by this Federal Funds Rate.  And when there are fewer loans being made, that means fewer businesses are able to get money they need to grow, pay workers, buy capital, etc.  It also means fewer people can afford to buy homes and cars.

Anyway, at the blog, they chart the 10yr/3mo Treasuries spread against the Federal Funds Rate and determine the probability that the U.S. economy will be recession 1 year from the date they are making these calculations.

According to Political Calculations, on November 3, 2011, the probability that the U.S. economy will be in recession on November 3, 2012, was 0.01% up from a 0% chance in July.  So, there’s a chance!

High Yield Bond Spreads

The interest rate that investors expect to receive when they loan money to companies that have a higher chance of not paying back should be higher than what they expect to receive from money that they loan to the U.S. Government.  In other words, “junk bond” yields should always be higher than Treasury yields.  But the amount of that difference provides us some clues about where the economy is headed.  That is, if it’s very high, that means investors are nervous and not interested in as much risk.

Right now, this spread is elevated from the levels we saw in July, but it has come back down from the highs we saw in early October, according to the Federal Reserve Bank of St. Louis.  So, while the alarms are not sounding just yet, any shock to the financial system could easily hurt these spreads.

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Method #2: A Proprietary Model

Quick ‘n Easy There are some companies that analyze the economy without publishing their methods.  A couple of these are Moody’s Analytics and the ECRI.  Moody’s gives about a one-in-three chance that a recession will begin by mid-2012, while the ECRI maintains it is a certainty.

Moody’s Analytics

On their website at Economy.com, they list the following as their definition for their “Risk of Recession” indicator:

The probability that the U.S. will be in recession in six months, calculated using regional leading indicators by Moody’s Analytics.

Their methodology is proprietary (A.K.A. they’re not going to share it with you or me), so I will simply say that I generally find their work to be credible.  And so, let’s see what they say.

According to Moody’s Analytics for data through November 2011, the risk that the U.S. economy will be in recession in May 2012 is 34%, down 6% from the previous month.

Economic Cycle Research Institute (ECRI)

The Economic Cycle Research Institute (ECRI) publishes a series of indexes and provides analysis on the economic cycles.  At the end of September, the ECRI predicted that we are definitely headed for a recession, and they have reaffirmed that prediction despite apparent strengthening of the economy, citing that their forward-looking indicators are still flashing warning signs.  The company has many forward-looking indexes that predict economic activity many months in advance.  They felt that there was a “contagion” of negativity spreading among those indicators, which means that there is no way to avoid an oncoming recession.

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Method #3: Measurements of Economic Activity

Quick ‘n Easy An index combining 85 indicators into one number suggests that the economy was growing at a slower-than-historical-average rate in November 2011 but not slow enough to be considered in recession.

Chicago Fed National Activity Index

The Federal Reserve Bank of Chicago combines 85 different indicators into one number to give a sense of whether the overall U.S. economy is growing (numbers above zero) or shrinking (numbers below zero).  If you average the last three months’ index values, you get the CFNAI-MA3 (“moving average 3 months”).  According to the Chicago Fed:

When the CFNAI-MA3 value moves below -0.70 following a period of economic expansion, there is an increasing likelihood that a recession has begun. Conversely, when the CFNAI-MA3 value moves above -0.70 following a period of economic contraction, there is an increasing likelihood that a recession has ended.

Here’s a chart of the index with values through November 2011 (they release the data for a particular month during the late part of the next month):

The latest reading of the moving average CFNAI-MA3 is -0.24 thru November 2011, which does NOT signify that a recession has begun.

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Method #4: Annualized Real GDP Growth Rate

Quick ‘n Easy If we measure the real GDP (Gross Domestic Product) compared to the same quarter the previous year, if it is less than 2 percent higher, it is nearly certain that the economy is in recession or will enter one within a year.  This is based on data since 1950.  Since the 2nd quarter of 2011, the annual change of GDP has, in fact, been lower than the 2 percent warning level.

According to a Wells Fargo research report:

Every time real GDP growth has decelerated to less than 2 percent on a year-to-year basis the economy has either already been in recession or fallen into one within a year.  The record is not very comforting.  There were 11 instances since 1950, and in all 11 this rule held true.

Here’s a chart of the real GDP (Easy Intro) change versus the same time the previous year (annual growth rate).  In the second quarter of 2011, the growth rate dropped below that 2.0 percent mentioned above by Wells Fargo as a threshold for an impending recession, coming in at 1.6 percent.  It has stayed that way through the final estimate for 3rd quarter 2011 as well (1.5 percent).

 

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Method #5: Electronic Trading Markets – People Making Bets

Quick ‘n Easy When a large group of people put their money where their mouths are, we can typically get a good prediction of almost anything.  In an electronic trading market, the way people are placing their bets right now, there is about a 26-29% chance we’ll be in recession at some point in 2012.

Intrade.com

Intrade.com is basically like a stock market except that, instead of buying companies you are buying an outcome of something, like an election or whether something will happen.  People win and lose real money, so when there are enough people trading something, we can get a reasonably good estimate of what the “crowd” thinks will happen.  And that is usually a pretty good bet.

According to trading as of yesterday, there is a 26-29% chance that the U.S. economy will be in recession at some point in 2012.

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Method #6: Recession Signature

Quick ‘n Easy John Hussman has identified a set of conditions that, when they have occurred together historically, have always been associated with either a recession that was ongoing or one that was about to happen.  Each of these conditions by itself is not necessarily enough to sound the bells, but together they are powerfully predictive.  These conditions were in place several months ago, which means that we are either in a recession (not likely given other data that has come out in late 2011) or about to enter one.  He recently estimated the probability of a recession in the near term at about 85 percent.

Hussman Funds Recession Warning Composite

John Hussman has created a set of conditions that, when they have occurred together historically, have always been associated with either a recession that was ongoing or one that was about to happen.  Each of these conditions by itself is not necessarily enough to sound the bells, but together they are powerfully predictive.  Here are the conditions, along with an Easy Translation for the ones that have difficult concepts, so you don’t have to wonder what they mean:

1: Widening credit spreads: An increase over the past 6 months in either the spread between commercial paper and 3-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields.

Easy Translation: If the perceived risk of loaning money to companies versus loaning to the U.S. Government has gone up in the last 6 months, condition #1 would be met.  In other words, companies would simply not be in a very good position.

2: Falling stock prices: S&P 500 below its level of 6 months earlier. This is not terribly unusual by itself, which is why people say that market declines have called 11 of the past 6 recessions, but falling stock prices are very important as part of the broader syndrome.

3: Weak ISM Purchasing Managers Index: PMI below 50, or,

3: (alternate): Moderating ISM and employment growth: PMI below 54, coupled with slowing employment growth: either total nonfarm employment growth below 1.3% over the preceding year (this is a figure that Marty Zweig noted in a Barron’s piece many years ago), or an unemployment rate up 0.4% or more from its 12-month low.

Easy Translation: For condition #3 to be true, it could either be that the ISM Purchasing Managers Index comes in at a reading below 50, or it could be below 54 along with some measure that the employment situation is worsening.

4: Moderate or flat yield curve: 10-year Treasury yield no more than 2.5% above 3-month Treasury yields if condition 3 is in effect, or any difference of less than 3.1% if 3(alternate) is in effect (again, this criterion doesn’t create a strong risk of recession in and of itself).

Easy Translation: Basically, the flatter the yield curve is, the more likely a recession is coming.  The yield curve looks at the interest rate on Treasuries depending on the length of the loan you are giving to the U.S. Government.  If people require just as much interest rate on short-term loans as they do long-term loans, it means they believe the economy is about to weaken significantly.

Several months ago, all four conditions of the Hussman Recession Warning Composite were met.  Although there has been some fluctuation in some of the signals since then, it doesn’t change the fact that the recession signature was met.  So, if history is any guide, we are either in the middle of a recession, or one is just around the corner.  Furthermore, Hussman combines numerous recession indicators into one “estimated probability of recession” that recently showed about an 85% chance of recession in the near term.

We must assume the risk of recession is real.  This risk ranges anywhere from about 26-100% thru mid-2012.