Slump-Watchers Dump Yield Curve for 1970s Tool: Cutting Research

Nov. 27 (Bloomberg) -- The U.S. Treasury yield curve has lost its forecasting power and investors wanting to divine the possibility of a U.S. recession should turn to a little-known equation from the 1970s.

That’s the recommendation of Morgan Stanley economist Ellen Zentner, who told clients in a Nov. 18 report that the Federal Reserve’s near-zero interest rate and asset-buying is holding down U.S. bond rates. That means the yield curve would struggle to invert, crimping its effectiveness as an indicator of business cycles, she wrote.

An inversion occurs when three-month bill yields top those of 10-year notes, signaling investors are betting on weaker economic growth. Recessions have followed six of the eight times that’s happened since 1960; there hasn’t been a U.S. recession that wasn’t preceded by an inverted curve in the period.

An ideal leading indicator would exclude components such as the yield curve that behave perversely during times of financial stress, said New York-based Zentner. She suggested investors look at the Duncan Leading Indicator, devised in 1977 by Wallace Duncan, then of the Federal Reserve Bank of Dallas.

The DLI looks at components of the U.S. economy that react to cyclical demand, such as household spending, and compares them with economic growth. If these factors grow faster than final demand, a peak should precede a decline in activity.

Since 1970, the DLI has indicated imminent downturns by an average of four quarters. A 1985 study by the Federal Reserve Bank of San Francisco found it a more reliable indicator of business cycle peaks than other tools.

An upturn in the DLI since the second quarter of 2009 confirmed the end of the last recession and its subsequent gain over the past 17 quarters indicates the risk of an economic slump next year remains low, Zentner said.

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Speculation that quantitative easing could end up causing deflation led Paul Mortimer-Lee of BNP Paribas SA to study whether asset-buying by central banks might backfire.

In a Nov. 22 report he studied the possible arguments why QE could undermine prices, rather than boost them as conventional wisdom suggests. Among them: the purchases could damp consumption because people know any increase in wealth is temporary or lead them to expect even cheaper borrowing costs in the future. Those living on interest-earning income suffer, as do workers unable to enjoy the resulting rise in asset prices.

The programs could also suppress prices by triggering overinvestment, encouraging poor spending decisions or creating bad loans, as has happened in China. QE also risks inflating asset bubbles, which hit economies when they burst. And governments that expect central banks to have greater success may be too quick to tighten fiscal policy.

Mortimer-Lee, global head of market economics at BNP Paribas, is more upbeat than the skeptics. The arguments that QE can choke consumption could apply to any easing of monetary policy and the Fed’s three rounds of asset buying have added about 1.5 percent to U.S. consumption, he said.

Critics also can’t be right that quantitative easing both stimulates and deters excess investment, he said. In China, capital accumulation has depressed producer prices and profits, but it was driven by government policy.

While he sympathizes more with the threat of asset bubbles, market distortions are often needed to help the economy, he said. As for the action of governments, it’s been the euro zone that has embraced austerity the most, even though the European Central Bank hasn’t bought bonds.

“As far as we can see, the evidence to date suggests that QE is not deflationary,” he said. “While QE may have a limited effect on activity, it has probably helped to fend off deflation.”

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Japan’s stagnation doesn’t provide a template for the euro area, according to Commerzbank AG.

While Morgan Stanley recently suggested the potential for a “Japanification” of the euro region in the form of falling prices and slumping growth, Commerzbank economists Ralph Solveen and Bernd Weidensteiner said there is little reason to worry.

Prices fell in Japan not because of a weak economy but because their level stayed elevated during the preceding boom and needed to be corrected, the economists said in a Nov. 22 report. Data suggest prices in Japan in the mid-1990s were 80 percent higher than in the U.S.

In the euro area, however, there was no such jump in prices, so inflation is likely to grow at an annual rate of 1 percent. The exception is the so-called peripheral economies, such as Greece and Spain, where a price correction is now under way, they said.

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Ukraine, Turkey and South Africa are the emerging markets most vulnerable to the Fed’s plan to eventually slow asset purchases, according to Bank of America Corp.

China and South Korea should be the most resilient to any decision by the Fed to taper its $85 billion of monthly buying, the economists wrote in a Nov. 25 report to clients. Their conclusions were based in part on a so-called vulnerability index that allows for factors such as a government’s debt and the nation’s current account balance.

The results showed Ukraine and Turkey suffer from high external debt and a lack of reserves, while South Africa is weakened by its current account deficit. By contrast, South Korea benefits from low inflation volatility and a strong fiscal position. China enjoys a current account surplus and large currency reserves.

There may be some comfort if the Fed’s pullback of stimulus is driven by a recovery in the U.S. economy, the Bank of America economists said elsewhere in the same report.

A one-percentage-point shock to U.S. growth would have the most durable impact on Mexico but also provide a pickup for South Korea. The effect would be more moderate on Turkey and India, adding about 0.2 percentage points to expansion, and modest and short-term for China.

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Recessions threaten to dim the brainpower of those who risk losing their jobs during them.

Using data from 12,020 people in 11 European countries, a study published this month in the Journal of Epidemiology and Community Health found men 45 to 49 years old who suffered through an economic slump showed worse cognitive functions when they reached the ages of 50 to 74. Among women, recessions between the ages of 25 and 44 helped slow cognitive functions 25 years later.

The results suggest that losing work or having to accept part-time positions could hurt the brain, the authors said in the study.

“Policies that ameliorate the impact of recessions on labor market outcomes may promote later-life cognitive function,” said authors Anja K. Leist of the University of Luxembourg, Philipp Hessel of the London School of Economics and Mauricio Avendano of Harvard School of Public Health.

To contact the reporter on this story: Simon Kennedy in Paris at

To contact the editor responsible for this story: Craig Stirling at

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