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Thursday, September 07, 2006

Economic Growth Is Clearly Slowing But Is A Recession On The Horizon?

By Yaser Anwar, CSC of Equity Investment Ideas

According to the Fed Reserve's main assessment of regional conditions, economic growth slowed in numerous parts of the country as housing activity continued to cool and consumer spending expanded at only a sluggish pace (blame can be put on rising energy prices & credit crunch to less jobs as a housing multiplier effect). The September report marks the third consecutive survey period in which decelerating growth has been a main theme of the Beige Book.

Does an inverted yield curve necessarily mean that there's a recession coming? Every US recession in the post World War 2 era had been preceded by an inverted yield curve. Since then, the inverted yield curve has only given two false signals.

Once, in 1998, may have been caused by some extraordinary occurrences: At that time, the inversion was blamed on investors getting into what they thought was the comparative safety of long-term government bonds in the wake of the demise of hedge fund LTCM and the Russian meltdown.

Second time during '98-2000 era. “It’s different this time” is the reasoning most Wall Street banks used when the yield curve inverted in 2000, after which the stock market crashed and the economy went into recession.

As these investors purchased long-term government bonds, it increased their demand, thereby driving up the price of the bonds and subsequently lowering their yield.

A research paper by Fed Reserve Bank of New York economists Arturo Estrella and Mary R. Trubin makes a compelling case.

In "The Yield Curve as a Leading Indicator: Some Practical Issues," Estrella and Trubin quantify a relation between the yield curve and the economy. By analyzing the 10 year Treasury maturity rate and the secondary market 3 month Treasury bill rate on a bond equivalent basis.

The author's findings: "all six recessions since 1968 were preceded by at least three negative monthly average observations in the 12 months before the start of the recession," they wrote in the paper.

"The negatives tend to come in bunches," Estrella said to Caroline Baum of Bloomberg in a phone interview last week. She also mentions that this past August was the first time that the monthly average fell into negative territory. When long-term rates are below short-term rates, it's known as an inverted yield curve.

"The inverted curve can be viewed as a reflection of monetary policy (the Fed raises short rates, slowing growth and reducing inflationary pressure and long-term rates) or investor expectations (of lower short rates), according to Estrella," says Baum.

The way to reverse an inverted yield curve is for the Fed to either lower short-term rates or hope the markets push long-term rates higher. But the Fed, despite a pause at its last meeting, shows no signs of wanting to pull back the federal funds rate, its key interest rate that determines short-term rates. Instead, some Fed officials are arguing to continue the rate increases.

Whether a recession is on the horizon remains to be seen. Yesterday's productivity numbers didn't help, however we still got important data coming out that will help the Fed assess the tide before jumping the interest rate gun.

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