Are We Going Into Recession Soon?

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Includes: SPY
by: Donald Lingerfelt
Summary

There has been much concern about a coming recession and when it may occur. In my opinion, we are not threatened by any recession any time soon.

Interest rates are the main driver of the market, along with open market activity by the Fed and the general sentiment of investors.

One of the most important way to analyse the economy is with the yield curve and through real interest rate study.

A lot of talk lately has been about whether or not we are going into a new recession. In my opinion, we are not. I can say this for a number of reasons, based on my analysis of the market, interest rates, and my own economic coincidence recession indicator.

The market is driven by many things, but mainly interest rates. When a company needs to expand its production or embark on a new project, it must usually borrow funds to do so. At other times, to continue business according to its own particular strategy, they may borrow just to make payroll. Many business strategies rely on the ability to borrow from banks as a normal business activity. When interest rates rise or the banks see problems with a particular company, it becomes more difficult to borrow, or to borrow at acceptable rates.

That is why when interest rates rise, company viability comes into question. Banks are less accommodating to lending, knowing if they wait they will receive a higher return on their loans or that the company might be less fit to repay than before. Also, since interest rates have risen, profits will decline because of increased costs of borrowing and the present value of the whole company (based on the net present value of the company’s assets has declined). Investors know that this is going to happen, and their valuation of the company drops. Many investors will sell or be reluctant to buy, causing the stock value to drop accordingly.

We know that the relationship between the 10 year TBond and 90 day T-Bill shows how much the Federal Reserve Bank is manipulating the market rate of interest and thus the borrowing activity generally. When the Fed wants to slow borrowing (in hopes that price inflation will be slowed) they can do two things: Raise rates for the lower end of the yield curve (discount rate, T-Bills, Fed Funds, and/or revise reserve requirements), and buy (sell) bonds into the market, altering the demand (supply) which either adds (removes) liquidity, and raising (lowering) longer term rates. We can track these things a couple of ways. First is to chart the difference between the bond and bill.

The following chart is of the two instruments together:

Data Source: Barron's, charted on Excel by myself.

The chart below shows the difference between the two:

Data Source: Barron's, charted on Excel by myself.

Looking at the two charts shows some interesting things. Those who are familiar with recent recessions will see that the line above drops below the “0” line twice, preceding the last two recessions by about six months each. The yield curve dropping below the “0” line is known as an inverted yield curve. This is an excellent indicator for an upcoming recession. Recessions generally happen about six months after this relation occurs almost every time. It leads one to question why the Fed would cause this to happen if they know that the recession will occur if they intentionally create this state of affairs. The curve is currently not below the zero line, which indicates that so far we are not in danger. It may not invert soon either, which would be great for everyone. A slow and steady increase of rates would stave off that event for a long time to come, and this seems to be what the Fed is trying to do.

The Fed does this intentionally for a couple of reasons. First, their intent is to slow price inflation which corrects their loose monetary policy which is one cause for rising prices. Their job is to keep inflation in control (an interesting concept as inflation is increasing the money supply, which is what they do all the time). The second is to encourage business activity and low unemployment (by monetary policy - printing money) measured by GDP and the unemployment rate. What encourages GDP and higher employment? Low interest rates. Low interest rates are normally caused by higher saving, but low interest rates discourages saving. The balance is kept by the free market in interest rates by reacting to the supply and demand of loanable funds. If the return on saving is below the price inflation rate then investors (and the public) are encouraged to dissave because saving returns less than inflation. It is wasteful to save. The Fed makes up for this by artificially lowering the rate of interest so business can borrow at a profitable rate. Consumers would rather spend their money rather than save, increasing consumption which is something the Fed wants anyway. The consumer loses on all counts.

We can chart the incentive to save by the following chart of Real Interest Rates (T-bills vs. inflation):

Data Source: Barron's, charted on Excel by myself.

Note that for most of the last decade, the return on savings is less than zero. There was no incentive to save. As we know from economist F.A. Hayek, saving is what propels the economy forward, not consumption. The Keynesians disagree with this as they think that saving is “lost” to the economy, not understanding that saving does two important things: It provides funding (without money printing) for business and an investment for individual savers for their future. The recent increase in real interest rates is one of the major causes of the economic expansion we have been experiencing.

In my opinion, interest rates are not nearly high enough and should rise to “normal” levels to be an effective incentive to save. One and a half percent is not high enough.

There are other ways to indicate if a recession is approaching. Watching the unemployment rate, non-farm payrolls, consumer spending, large consumer goods sales, and industrial production are other good indicators. I have made a combination graph of these important numbers to create an indicator that gives a good general idea of where the economy stands in relation to the next recession. I show this below:

Data Source: Barron's, charted on Excel by myself.

You can see from the graph that the line drops below 5.1 just before the advent of a recession. Looking at the current level of the line at the far right, we see that the economy is very strong at the moment. Even though the market is in a short-term down trend, the major trend is still up. Hopefully this will assuage fears that a recession is just around the corner.

The stock market generally follows the same pattern as this composite indicator does, except the peaks and valleys are about 3-4 months sooner. The chart below shows the relation (year over year) of both the S&P 500 and the indicator:

Data Source: Barron's, charted on Excel by myself.

Conclusion

We are not in a recession at the present time, nor should we be in one for the near future. The yield curve shows us in a relatively good position as does the Composite Business Cycle Index. The real interest rate is improving and encourages saving for the first time in many years. Overall, I think that we are in pretty good shape economically speaking. I am bullish on the market long-term, and will only reverse when my signals tell me to.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have free commentary daily on my website Elington.com. I am currently invested in Bearsh ETFs, but my long term outlook is bullish.