Double Dip? The Bond Market Says No, But Stocks Aren't So Sure

Last Updated Jul 17, 2010 12:23 PM EDT

We've just been through an eventful, maybe even a watershed, week in terms of economic news. The stock market did not approve, falling about one percent for the full week, but nearly three percent Friday, as soft earnings from some leading companies raise fears of another fall into recession. But according to economists at the Cleveland Federal Reserve, the bond market is showing more optimistic readings, saying there is little probability of the dreaded double dip.

The week started well for corporate earnings, and the stock market's rise through Thursday seemed like a positive interim report card on the economy. Alcoa, Intel, JPMorgan and CSX, giant companies with operations in many economic sectors, all beat analysts' forecasts of earnings.

On Friday there was all sorts of news. Some seemed to put the bad stuff behind us: the SEC's settlement with Goldman Sachs; progress on capping BP's gushing oil well; and passage of new financial regulations.

What prevailed, however, were some unpleasant reminders: consumer confidence below forecast and falling; poor earnings from General Electric; and slower growth in the Chinese economy.

From Bloomberg, on consumer confidence:
The Thomson Reuters/University of Michigan preliminary index of consumer sentiment decreased to 66.5, the lowest since August and less than the most pessimistic forecast of economists surveyed by Bloomberg News. Another report showed inflation cooled last month.
The sentiment figures showed a record-low share of Americans expected their incomes will rise in the next 12 months, underscoring growing pessimism over employment prospects. Declining confidence may further restrain consumer spending, which accounts for 70 percent of the economy, and hinder the recovery in coming months.
An excellent piece by Motoko Rich in The NY Times reports on slower spending even among upper-income people:
[T]he Top 5 percent in income earners - those households earning $210,000 or more - account for about one-third of consumer outlays, including spending on goods and services, interest payments on consumer debt and cash gifts, according to an analysis of Federal Reserve data by Moody's Analytics. That means the purchasing decisions of the rich have an outsize effect on economic data. According to Gallup, spending by upper-income consumers - defined as those earning $90,000 or more - surged to an average of $145 a day in May, up 33 percent from a year earlier.
Then in June, that daily average slid to $119. "I think a lot of that feeling that the worst was over has sort of abated," said Dennis J. Jacobe, Gallup's chief economist.
But on the other side of the financial markets, the yields on U.S. treasury bonds are saying there won't be a second recession, we learn from Joseph G. Haubrich and Kent Cherny, economists at the Cleveland Federal Reserve. Here's a graph of their model -- today's readings are low:


They remind us that recessions are nearly always foretold by an "inverted" yield curve, which arises when short-term interest rates are higher than long rates.
The rule of thumb is that an inverted yield curve...indicates a recession in about a year, and yield curve inversions have preceded each of the last seven recessions [including the current one]... There have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998.
They explain the meaning of other interest rate scenarios:
More generally, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth.
Astute readers already know that the current yield curve is very steep. Here is Haubrich and Cherny's take on the situation today:
Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.00 percent rate over the next year, just up from May's prediction of 0.98 percent. Although the time horizons do not match exactly, this comes in on the more pessimistic side of other forecasts, although, like them, it does show moderate growth for the year.
...[T]he expected chance of the economy being in a recession next June [has risen] to 12.4 percent, up from May's 9.9 percent and April's 7.1 percent, despite the slight rise in the spread. Recent data has shifted the predicted value upward, though it still remains low.
And they add the typical caution that this time things may be different.

This may be another instance of Nobody Knowing Anything, but it's a small comfort based on impartial real-world data.
  • John Keefe

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