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Recession Indicator Unreliable With Fed Rates: Cutting Research

The yield curve’s traditional and consistent reactions to Fed policy changes and investor expectations about inflation and the economy have made it a tool for prognosis in the past. Photographer: Brendan Smialowski/Bloomberg
The yield curve’s traditional and consistent reactions to Fed policy changes and investor expectations about inflation and the economy have made it a tool for prognosis in the past. Photographer: Brendan Smialowski/Bloomberg

Sept. 7 (Bloomberg) -- The bond market indicator that has predicted every U.S. recession since 1970 may have lost its forecasting prowess, thanks to the Federal Reserve.

Two rounds of quantitative easing by the U.S. central bank mean the gap between the 10-year Treasury bond yield and the rate on the three-month bill “has been severely distorted and therefore can no longer be relied on to convey a truthful assessment of the risks of recession,” wrote Stephen Jen and Fatih Yilmaz, founders of London-based SLJ Macro Partners LLP, in an Aug. 29 report.

The yield curve’s traditional and consistent reactions to Fed policy changes and investor expectations about inflation and the economy have made it a tool for prognosis in the past. For instance, an inverted yield curve, in which short-term securities yield more than those with longer maturities, is seen as a recession gauge because it reflects expectations for higher interest rates and slowing inflation.

What’s changed is the Fed’s ultra-easy monetary policy, which has brought interest rates close to zero. That has “significantly distorted the shape of the yield curve,” SLJ said.

Other business cycle indicators also have “pretty serious shortcomings,” the authors said. That’s because they are not well equipped to capture the growing impact of the financial sector and its wealth effect, the U.S.’s reliance on services, supply-side shocks in the labor market and globalization.

The SLJ report proposed an alternative approach, based on the idea that expansions have a “natural cycle” in which the chance of recession increases the longer growth runs. That suggests the risk of a downturn could be closer to 50 percent in coming quarters compared to the zero chance ascribed by the yield curve.

* * *

This time may be different.

That’s the conclusion of Deutsche Bank AG strategists, who have delved into the history books to see when various financial market indicators were last trading as they have done in recent years, amid the global financial crisis.

Their research showed 10-year U.S. Treasury bond yields hit their lowest in July since data began in 1790. Dutch 10-year bond yields were the weakest in June in 495 years, while the Bank of England’s balance sheet is bigger as a share of gross domestic product than at any time since 1830.

The U.K. central bank’s benchmark interest rate of 0.5 percent is also the lowest it’s been in 318 years of history. The previous record low was 2 percent.

The study also found that the U.S. has run a budget deficit for 40 of the last 44 years. The U.K. had a shortfall in 51 of the last 60 years. The German currency has “consistently outperformed” virtually every rival since the 1930s.

“In many cases there are no historical precedents for what we are currently experiencing,” Deutsche London-based strategists Jim Reid, Nick Burns and Stephen Stakhiv wrote in the Sept. 3 report, titled “A Journey into the Unknown.”

This suggests to them that the world economy’s underlying flaws are “worryingly unparalleled” in history and that anyone predicting the end of the five-year crisis is “operating outside of the scope” of the data.

* * *

Also reaching into the distant past, Steve Hanke and Nicholas Krus of Johns Hopkins University found several episodes of national hyperinflation that have gone unreported in academic and scholarly literature.

There have been 56 instances of known and previously unidentified hyperinflation, they said in a report distributed Aug. 31. The first known case was in in France in May 1795. At their fastest, prices rose 304 percent in a single month, the analysts wrote.

One missing case of hyperinflation was in the Democratic Republic of Congo in 1998. Hanke and Krus discovered it using the International Monetary Fund’s statistics database, calling it surprising that the episode had gone unnoticed.

“Hyperinflation is an economic malady that arises under extreme conditions: war, political mismanagement, and the transition from a command to market-based economy -- to name a few,” they wrote.

Another previously unreported instance was in the Philippines in 1944, when Japan occupied the country and replaced the Philippine peso with its war notes, dubbed “Mickey Mouse money,” the authors said.

“Their over-issuance eventually resulted in a hyperinflation that peaked in January 1944,” they wrote. “It should be noted that the U.S. Army, under orders from General Douglas MacArthur, did add a relatively small amount of fuel to the Philippine hyperinflation fire by surreptitiously distributing counterfeit Japanese war notes to Philippine guerrilla troops.”

Known cases of hyperinflation include the fastest two ever recorded. It took 15 hours for prices to double in Hungary during its period of hyperinflation between August 1945 and July July 1946, resulting in an equivalent daily rate of 207 percent, the report showed. In Zimbabwe from March 2007 till mid-November 2008, prices rose the equivalent of 98 percent a day.

* * *

The U.S. housing market drove the world into recession. The emerging American recovery may not be enough to lift it back up, according to UBS AG.

At home, the rebound in U.S. property prices should continue, bolstering confidence and spending in the largest economy as well as slowing the pace of deleveraging, UBS economist Andrew Cates wrote in an Aug. 31 report.

“Since the fundamental roots of the global financial crisis lay in the U.S. housing market it almost goes without saying that a recovery in that market could be of great significance,” said Singapore-based Cates.

That’s because U.S. housing affects growth elsewhere as Americans purchase consumer durable goods from abroad and the improvement in the U.S. economy pushes up financial markets. Cates’s research find that the slower pace of deleveraging may have already boosted global gross domestic product by 1.5 percentage points.

The trouble is, that’s offset by other factors such as China’s slowdown, the European debt crisis and the fact that many countries still run debts larger than they were before the crisis, said Cates.

The debt burdens “above all else, will continue to keep global growth restrained in the period ahead, notwithstanding the scope for U.S. housing and the U.S. economy more generally to contribute more positively,” he said.

* * *

China’s residential construction may peak in five years and remain above current levels till around 2030, according to Reserve Bank of Australia economists Leon Berkelmans and Hao Wang, providing continued demand for iron ore that is needed to make steel.

One billion Chinese will live in cities by 2030, or about 70 percent of the population, from about 691 million people now, the RBA economists projected. That urbanization means demand for steel will continue to increase as Chinese developers build more homes and make improvements in building quality, the analysts said in a research paper published Sept. 5.

“No country can compare to China in terms of the sheer scale of its urbanization,” the economists wrote. “Construction requires steel, which in turn requires iron ore, of which Australia is a significant producer. More intense use of steel, due to taller buildings and other amenities such as underground car parks, means that steel use by residential construction will grow at a faster rate than the volume of floor space built.”

A quarter of Australia’s exports, or about 5 percent of gross domestic product, goes to the world’s second-largest economy. Sixty percent of those shipments are a single commodity: iron ore.

“The medium- to long-term outlook for residential construction remains relatively strong in China,” the economists wrote. “While growth in urban residential construction is expected to slow, the level of construction is nevertheless expected to remain high for a prolonged period of time. The prospects for steel used in residential construction are stronger still.”

To contact the reporters on this story: Simon Kennedy in London at; Shamim Adam in Singapore at

To contact the editors responsible for this story: Craig Stirling at; Stephanie Phang at

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