Download THE DREADED “R” WORD

THE DREADED “R” WORD
30
TH
JANUARY 2008
PROFESSOR ANDREW CLARE
THE DREADED “R” WORD
Recession - the dreaded “R” word – has been in the news a great deal recently. It’s a word
that needs to be used carefully. The more it is used and talked about the more likely the
phenomenon itself is to appear. If households and corporations believe they are entering a
period of recession, at the micro level the sensible response is for consumers to increase
saving and to reduce frivolous expenditure, while firms will naturally seek to cut back on
employment and investment plans. Though wise at an individual level, if many economic
agents do this at the same time we end up with exactly the economic environment that
made us so fearful in the first place.
According to some the US economy is already in recession, though this view does depend
on one’s definition. The technical definition of a recession often used by economists is two,
or more consecutive quarters of negative growth. Neither the US nor any other major
economy have experienced this yet. But the US’s National Bureau for Economic Research
(NBER) has a more eclectic definition, which includes a consideration of the rate of
personal income growth, on labour market conditions, on industrial production and on the
state of the manufacturing sector. Because of their wider definition of recession, it is
perfectly possible that according to their definition, the US recession has already begun.
Unfortunately the NBER usually only come out with their pronouncement as to when the
recession began and ended some time after each of these events. The financial markets
however have to try and arrive at their assessment of the future economic environment
much sooner.
Government bond market participants are particularly tuned in to the likelihood of any
future recession. You could almost say that they live for such events. The fall in economic
growth and the rise in risk aversion which accompanies these unhappy times for everyone
else, nearly always gives their asset class a major boost. And if we are to judge the
likelihood of a recession based upon the current sentiment in the US Treasury bond
market, then if the recession is not here already it is only just around the corner.
This week’s chart shows the yield on ten-year US Treasuries. At the time of writing tenyear yields are hovering just over 3.50%. If the yield on a ten-year government bond
should reflect compensation for real economic growth, expected inflation and a risk
premium related to the uncertainty surrounding the economic environment, then 3.50%
compensation for a ten-year investment would seem to be a poor reward indeed, unless
that is, the economy is going to hell in a hand cart.
The last time bond investors were this pessimistic was in mid 2003 when ten-year Treasury
yields slumped to just over 3.0%. However, rather than experiencing a deep recession in
the months that followed the US economy forged ahead, with growth, job creation and
profits all growing strongly.
Back in 2003, the bond markets got the US outlook wrong. By contrast the equity markets
got it right. US and global equity markets began to rise rapidly well before the bond
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markets had given up all hope of economic growth. Equity investors correctly anticipated
the economic upturn, while government bond investors still believed that the mother of all
recessions was nigh.
So with US Treasury yields at similar levels now, have they got it wrong again this time ?
Well, if they have then the equity markets have called it wrong too.
Although the major equity indices have stabilised recently most are still well down on their
highs of last year. It seems at the moment that the only news that can rest equity investors
from their gloomy mood are Fed rate cuts. But even these only seem to be able to revive
spirits temporarily before the despondency sets in once again.
US ten-year Treasury yield
8.0
Treasury bond yields, % pa
7.0
6.0
5.0
4.0
3.0
Source: Reuters-EcoWin
2.0
2000
2001
2002
2003
2004
2005
2006
2007
2008
The Fed’s latest 0.50% rate cut is a clear sign that the Fed agree with the markets. A US
recession may already be here based on a looser definition of the phenomenon. The Fed’s
focus, and drastic action, are now clearly focussed on trying to avoid a more general
contraction in the US economy, and in particular a protracted contraction.
The dreaded “R” word is likely to rear its ugly head in the media many more times in the
next few months as the Fed tries to steer the US economy towards more benign waters.
And in fact it has appeared 13 times in this article!
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