Are We Headed for a Recession? Ask an Economist…

dadIf your work touches the restructuring world (or if you’re married to one of us), you know that one of our favorite topics of cocktail and conference small talk is to speculate about when a recession will hit.  And when work will pick up. Now, many of you have lawyers and accountants in your families. It just so happens that I have a family economist, Dr. Michael M. Kurth, Ph.D.

So this week, let’s ask dad: “Are we headed for a recession?”  (And yes, the following dialog really is representative of family dinner conversation at my house.)

Trump Claims That We Are in the Midst of a Tremendous Economic Expansion That Makes This the Greatest Economy in the HISTORY of America…. Is that True?

Well, Daughter.  (There are six of us.  He can’t keep track.  So I am “Daughter.”  Or as I prefer, “First Daughter.”)  There is no question that investment has soared after Congress cut the corporate tax rate from 21% to 35%. And we currently have record low unemployment.

Is This Economic Performance Sustainable or Is a Recession Coming?

The president’s economic team claims that gross domestic product (GDP) will be growing at a rate of 5% or more by year end.  But there are growing indications the economy may be headed in the opposite direction.  The most recent sign of an impending recession is the flattening of the yield curve that measures the difference between short-term and long-term interest rates.

How Reliable Is the Yield Curve in Predicting a Recession?

Its a very reliable indicator.  It has predicted every recession for the last 60 years.  Here’s how it works.  (In case you were going to ask...)

The yield curve is normally upward sloping, indicating that long-term interest rates are higher than short-term rates. This is because lenders and investors generally consider long-term loans to be riskier than short-term loans and they require higher interest to compensate them for the additional risk.  (That makes sense.)

When the yield curve turns negative – referred to as an “inverted” yield curve – it means that short-term interest rates are higher than long term rates.  That, in turn, suggests that lenders and investors consider the short-term riskier than the long-term. This has happened 10 times since 1955 and 9 of those times it was followed by a recession within about a year.  (If we were at my house, he would graph this for you on a napkin.  Paper or cloth.  Seriously.  For this blog, however, you get a proper graph, below.)

graph

The one time it wasn’t followed by a recession was 1966, when it was followed by weak growth… But technically not a recession. (Seriously, dad?  I wasn’t even born in 1966.)

So, I Understand How It Works.  Is the Yield Curve Flat Today?

Well, Daughter. Currently the yield curve is still positive and upward sloping.  But it has been steadily getting flatter. The differential between short and long-term rates are now just .32% compared to a normal spread of around 2 to 2.5%.  (Ahhhhh…!)

What Are  Some Possible Explanations for This Flattening Yield Curve?

Funny you should ask. (He was going to explain anyway.) You know about the “Trump Bump.” The stock market had a significant surge after Donald Trump was elected president.  During his first year in office, the Dow Jones Index went from 18,259 to 26,392, an increase of nearly 50%. But… in January it shed 2,500 points in two weeks.  And it has been bouncing around the 24,000 point level ever since. (Visualize my dad bouncing salt shakers across the edge of the table to illustrate here.)

  • One explanation is that investors are getting spooked by uncertainty over trade wars and other Trump policies.  Just take a look at the Cboe stock market volatility index. It averaged 11.85 in 2017. But so far this year it is averaging 16.94.
  • Also, many investors are “baby boomers” who either retired or are nearing retirement age.  After the big market rally, they seem more interested in preserving their stock market gains than taking additional risks.
  • And from a broader perspective, the Obama Administration kept interest rates near zero for eight years to stimulate investment. At the same time, the federal government borrowed massive amounts of money from abroad in an effort to spend our way out of the recession. But the artificially low cost of capital distorted the capital structure of our economy.  That means significant over-investment in the most capital-intensive sectors.  (Ah… so Republicans can blame this all on Obama administration policy failures?)
  • Not so fast, Daughter. The Federal Reserve Bank knew its policy of “quantitative easing” was unsustainable and was poised to raise interest rates as soon as the economy improved. But with unemployment at historic lows, the Trump administration decided to pour even more money into the capital markets.

(Do you have questions about how quantitative easing works? Here is my favorite explanation ever: Quantitative Easing Explained.)

So You’re Describing a Boom and Bust Cycle… Is This Cycle Inevitable?

Well, we’ve seen this before.  In the Austrian school of economics, it is known as the over-investment theory of the business cycle. According to this theory, there is a natural structure to investment in the economy based on people saving and investing. Boom-and-bust business cycles are created by temporary injections of funds into the capital markets that lead to low interest rates and investment levels that cannot be sustained. Sustainable growth comes from people saving to finance investment, not temporary injections of capital that create the illusion of prosperity.

Okay, Wait… What I Really Wanted to Know Is Whether the Yield Curve Is Signaling That the Big Boom is About to Turn Into a Big Bust?

Right, Daughter! Some financial analysts argue that the yield curve doesn’t apply to our new, technology-driven economy and that there are still many unexploited profit opportunities out there. They are urging the Federal Reserve Bank not to raise short-term interest rates. And they will likely blame the Fed if they do raise rates and a recession ensues. (Wait… I’m a bankruptcy attorney.  Isn’t a recession good news for me and my colleagues?)

Well, yes, Daughter.  Some people may be rooting for a recession for perverse incentives. (Paternal stink eye.) Or for political reasons. An economic downturn, for example, could be bad news at the polls for Trump and the Republicans. (The big tax cut was more a Republican idea than Trump’s idea).  I am not among them. We need economic growth to pay just the interest on the $20 trillion debt our government has amassed.  And it’s not just the US. The world is awash in $164 trillion of debt, which will make it harder for countries to respond to the next recession and pay off debts if financing conditions tighten.

So What Does Your Economist’s Magic 8 Ball Predict for the Upcoming Year?

The big economic stories will be inflation, higher interest rates, and a declining stock market. This is very much at odds with the picture the Trump administration has painting as it poured “rocket fuel” onto the economy. And I am not rooting for a recession. (Stink eye again.) As an economist, I’m just informing you of the situation as I see it so you can take precautionary measures.  (Like taking vacation now, before the recession wave hits….?)


If you would like to know more about this, google “an inverted yield curve” and decide for yourself.  Or I can give you my dad’s email.

Mette K.

 

 

One thought on “Are We Headed for a Recession? Ask an Economist…

  1. Mette, good explanations from your Dad. I really like the allusion to dancing salt and pepper shakers as demonstrative devices. My daughter will confirm I do things like that when giving her Dadly explanations

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