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.

Two recoveries

My hypothesis is that we are poised for a recovery that is qualitatively similar, though somewhat slower, than the recovery of 1983-84. The economy has probably been growing since about July 2009. The 1981-82 recession hit its trough in the third quarter of 1982; GDP started to increase around October 1982. So May 2010 is analogous to August 1983. What did the economy look like in August 1983? This graph compares payroll employment growth for the first 10 months of each of the two recoveries.

The beginning of the increase in GDP at the end of 1982 was followed by three months of declining employment, a "false alarm" increase in January 1983, two months of flat employment, and then a strong rebound. Beginning in July 2010 we had four months of declining employment, a "false alarm" increase in November 2009, three more months of flat employment, and then what looks like the beginning of a strong recovery. So we seem to be about two months behind where we were in 1983.

In May 1983, two months into the employment rebound, the consensus forecast for GDP growth over the next year was in the neighborhood of 4.5%, which news reports acknowledged was somewhat slower growth than was typical of post-war recoveries. Over the next four quarters GDP grew at an annual rate of around 8 percent. Today the consensus forecast is for growth for the next year in the neighborhood of 3.5 percent...

I'm certainly not saying we're going to have growth of 8 percent over the next year. And this is not evidence that we're going to have a strong recovery. But let's put it this way: the data we have as of today does not contradict the hypothesis that we will have a strong 1983-style recovery.

Financial headwinds you say? In spring 1983 the Baa-Aaa interest rate spread was in the neighborhood of 170 basis points; today it's around 100. So to make the case for a slower recovery you need to appeal to special threats facing the US economy today that weren't around in 1983; certainly the situation in Europe qualifies, but it's too early to say that that will sink the recovery.

TED spread continues to inch up

As of this morning:

The TED spread has climbed above 35, up from 31 a week ago.

The TED spread measures stress in interbank lending; credit spreads measure investors' aversion to risk.

Credit spreads

Recent movements in credit spreads (here the difference between yields on Baa and Aaa corporate bonds) tied to the Greek crisis are cause for concern:

But so far it's nothing like we saw two years ago:

The Baa-Aaa spread is important because it captures financial market participants' attitude toward risk. An increase in the spread means investors are shying away from risky securities and hoarding safe securities instead. This means that corporations face higher borrowing costs, which could reduce investment spending. It also reflects a general worsening of the psychological climate, which could mean lower spending across the board.

This is what people mean when they talk about the "headwinds" facing the economy as a result of financial stress. As I said in an earlier post, we're in a race between the forces of expansion and financial stress. Real economic expansion relieves financial stress - e.g. although Greece might still be having trouble servicing its debt if the world economy was not in recession, the other PIIGS (Portugal, Italy, Ireland, Spain) would be doing just fine. But financial stress retards economic expansion for the reasons given above. My money is still on the forces of expansion, but the increase in credit spreads has the potential to turn into something serious.

Is the economy slowing down?

There's a growing suspicion that the economy has begun to slow down since the end of 2010, perhaps as a result of rising oil prices, turbulence in the Middle East, renewed stresses in European financial markets, and budget cutting at the state, local and federal levels. I don't want to dismiss that possibility - all of those factors could very well have the effect of slowing the economy down - but my favorite economic indicator tells a different story. The Baa-Aaa credit spread, a measure of the risk-taking proclivity of corporate borrowers, has fallen since January and remains at quite low levels. We are not seeing the kind of upward bump that we saw last summer when the economy really did slow down and everyone was worried about a "double dip." So I shall remain cautiously optimistic for now.

The Great Inflation Scare of 2010

As previously noted, the recent rise in 10-year Treasury rates has raised concerns about inflation in some quarters. Paul Krugman writes of the rise in the term spread:

What the large spread now tells us is that the US economy is in the dumps now, but that investors see a reasonably good chance of a strong recovery in the not-too-distant future. That’s good news, not bad news.

More broadly, on the risks-of-default thing: surely if investors were growing worried about US ability to honor its debts, they would be worrying about a breakout of inflation as well as or instead of default per se. But we can track that by comparing interest rates on ordinary bonds and inflation-protected bonds. What we see is that from 3/17 to 3/30 — the period that inspired all those recent scare stories — the nominal interest rate on 10-year bonds rose by 26 basis points; the real rate rose by 28 basis points. So expected inflation actually declined, marginally.

Here's the data that backs him up. The red line is expected inflation as measured by the difference between yields on nominal 10-year Treasuries and inflation-indexed Treasuries. It went up a bit (5 basis points) last week, and since then has fallen about half way back down. It has been fairly stable throughout the month. The blue line is the credit spread - the difference between yields on Baa corporate bonds and 10-year Treasuries. It's been falling all month, and in fact fell a tad during last week's rise in the term spread. This suggests that what happened last week was a move out of Treasuries and into risky assets (simultaneous with a move from short-term to long-term securities), which is exactly what we want to have happen.

By the way, Krugman said nothing different from what I wrote in a post a couple of days before. Yet his mots justes inspire Brad DeLong to repeat his mantra:

Once again, the two rules:

1. Paul Krugman is right.
2. If you think Paul Krugman is wrong, refer to rule #1.

I definitely need to get me one of them Nobel thingies.

Monetary policy, bond markets, and the job-rich recovery

Hyman Minsky argued that monetary policy affects the economy in the following way. The Federal Reserve reduces short-term interest rates. There's now no profit to be made sitting on money, so financial managers shift funds out of short-term, risk-free assets into long-term risky assets like corporate bonds. The increased demand for bonds pushes their prices (which were low at the trough of the recession) up and their yields (which were high) down. Credit spreads (the difference between risky rates and risk-free rates) therefore plunge. Businesses can borrow more cheaply, so begin to undertake investment projects that they had delayed due to the recession. Consumers also face lower borrowing costs, so they loosen up, and the recovery is underway.

The story implies that a plunge in credit spreads, say as measured by the difference between the yield on Baa corporate bonds and 10-year Treasuries, should normally precede a recovery in employment. Look at the historical record:

1974-76: Baa-Treasury spread peaks at 3.31 in January 1975, falls to 2.49 by July. Strong growth in employment begins that month.



1981-84: Baa-Treasury spread peaks at 3.82 in October 1982, falls to 1.79 by August 1983. Strong growth in employment begins in April 1983 with spread at 2.89.



1990-94: Baa-Treasury spread peaks falls, rises, falls again in early stages of the "jobless recovery." The last peak, at 2.25, comes in October 1992. From there it falls to 1.29 by December 1994. Strong growth in employment begins December 1992.



2000-2004: Another jobless recovery, with Baa-Treasury spread bouncing around until it peaks at 3.79 in October 2002. From there it plunges to 2.03 by May 2004. Strong growth in employment begins in March 2004.



So what have we seen this time around? A much more severe jump in credit spreads (up to 6.0 in December 2008) and a much more severe recession. But there's been a continuous drop in the spread beginning in March 2009, and the spread is now at 2.65.



Today the WSJ reports on the rally in corporate bond markets, and it sounds like it could have been written by Minsky (or Barbera) himself.

Investors flooded risky companies with money in March even as the government prepares to shut down a key engine driving one of the greatest corporate-bond rallies in history. A total $31.5 billion in new high-yield debt, otherwise known as junk bonds, hit the market through Tuesday, exceeding the previous monthly record in November 2006. Partly propelling the activity: The Federal Reserve's massive mortgage-buying program, which comes to an end Wednesday. By buying $1.25 trillion of mortgage securities, the Fed absorbed a flood of assets that otherwise would have needed buyers. That kept money in the hands of investors, who went searching for something else to buy. The Fed's underpinning encouraged investors to seek riskier, higher-yielding securities. A natural choice: corporate bonds...

The revival of bond fortunes has roots in the Fed's decision, around Thanksgiving 2008, that may have done more than anything else to encourage more investors to take a flyer on bonds. On Nov. 25, the Fed announced it planned to buy debt and mortgage-backed securities issued by housing-related governmentsponsored entities such as Fannie Mae and Freddie Mac. The program pushed mortgage-security prices higher, giving fixed-income managers an incentive to sell to the Fed. In return, they had a flow of cash that had to be put to work. With Treasury debt yields at record lows, the best alternative remaining was corporate debt. "That was the big turning point," says Ashish Shah, head of global credit strategy at Barclays Capital. "That's what drove money into credit."

The Fed expanded this program on March 18, of last year, to buy $1.25 trillion in mortgage securities, along with $200 billion in debt of Fannie and Freddie and up to $300 billion in long-term Treasury debt. The expansion fueled the second leg of the rally, which hasn't stopped.

The behavior of credit spreads in the last year looks very much like it did in 1975-76, 1982-83, and 2003-04. The change in employment has been following a path similar to that in 75-76 and 82-83. It's taken us longer to hit zero this time around because the declines were so enormous during the recession. With monetary policy having delivered a 340 basis point reduction in credit spreads over the last year (compared to 82 in 75-76, 203 in 1982-83 and 176 in 2003-04), is it unrealistic to think we're on the verge of a strong recovery in employment? I don't think so.