Back to basics

Everything that was happening in the economy in March and April appeared to be vindicating my bold predictions of a strong recovery. Everything that's happened since then seems to argue against this and raises the possibility of a long drawn-out jobless recovery or even double-dip recession. What happened?

Well, one thing that happened is that beginning in May credit spreads - the Baa-Treasury spread in particular - jumped significantly due largely to the Greek crisis. Concerns about the European banking system and the European economy in general, and the possibility of a spillover to the US banking system and economy, caused investors to dump risky assets. This raised borrowing costs and credit availability, which together with a general sense of unease halted business expansion. As the graph below shows in this recession-recovery there has been a strong correlation between the Baa-Treasury spread and economic performance (here given by the change in private payroll employment).

If the slowdown of the last two months was driven by the souring of financial markets, then stabilization of the markets could cause the economy to return to a strong recovery path. The response to Europe's bank stress tests, the leveling off (and slight decline in the last week or two) of the Baa-Treasury spread, and stock market rallies therefore may be a signal of coming strength in the economy.

To be honest I'm not as sold on the strong recovery story now as I was a few months ago, but I'm not dismissing the possibility either.