Bill Gross writes about
A Gift That Should Keep on Giving in his Investment Outlook for January 2006.
Let’s take a look:
The historical 12-18 month lag between a tightening cycle/flat yield curve is what fools many analysts into thinking that yields are still stimulative and that the Fed has more wood to chop. It takes that long for higher yields to affect the housing market, mortgage equitization, and corporate investment cycles, whereas many economists feel it should work more like an anesthetic in the operating room where the patient counts backwards from 10 to 1 and is out before he reaches 5. It doesn’t work that fast. The Fed knows this, but often is willing to risk an overshoot and a curve inversion in order to insure benign inflation and sufficient economic slack over the foreseeable future.
Chart I shows but one of a series of graphs PIMCO uses to indicate when enough is enough – the point at which adjustable short rates rise sufficiently to make the owner of a home or a 5-year swap, or more importantly the economy, cry “no más!” That point comes in this example when Fed Funds rise to meet the average cost of intermediate Treasury financing issued over the past 5 years and the spread between the two disappears.
For those of you whose heads are turning, simply accept the fact that by the time the line in Chart I bottoms or hits 0, bond market yields have already peaked – in other words the bear market is over. Bear market ending dates of 1/00, 12/94, 3/89, and 5/84 can all be compared to 0-line or near 0-line bottom points indicating sufficiently onerous Fed Funds levels to slow the economy and end a bond bear market. Data points from the early 1980s backwards tell a similar story but are much more extreme since it was necessary for the Volcker Fed to go to super tightness in order to knock out accelerating inflation.
The sum total of last month’s Investment Outlook’s “secret” and this month’s Investment Outlook’s “gift that should keep on giving” is that yields have peaked in the bond market and will soon peak in Fed Funds producing an economic slowdown in 2006. If the Fed goes beyond 4½% and inverts the yield curve, the possibility of recession will increase. Observant readers will have already noted that the current data point in Chart I is not only calling for an end to the bear bond market, but a recession at some point 12-18 months hence. Perhaps. Much will depend on the future condition of the U.S. housing market and of course global economies – primarily of the Asian variety. We shall see. But for now, hopefully you can take solace from a new timing indicator that says the worst is over for bonds and an indicator that should keep on giving in terms of its reliability for years and years to come. Enjoy and Happy New Year…for bonds!
William H. Gross
I encourage everyone to click on the above link as Bill Gross has a lot more to say than I snipped.
Recessions and predictions in general were two of the things we discussed on a Howe Street podcast today January 4th 2006. Tune in if you want to see my successes and failures for 2005 as well as a discussion about how and why the upcoming recession might blindside everyone. We also talked about gold and the Baby Boomer Time Bomb. I will be posting a very long blog on the latter later this week. Previously I posted Mish’s predictions for 2006 and we talked about those on today’s podcast as well.
Please bear in mind that many things can go wrong with predictions even when the supporting evidence is all lined up. The market has a way of making a fool of as many people as it can as often as it can. In that regard, I am pleased to be in the same camp as Bill Gross at a time when the entire rest of the world seems to be tooting the “It’s Different This Time” horn by saying the yield curve does not mean what it used to. If everyone was worried about a recession, something would probably put it off, at least temporarily.
The fact that no one (including the FED) seems to think a recession is coming even with the yield curve flattening, means several things to me:
- The FED will not be reacting to prevent something they do not see coming
- The odds are the contrarians are more likely to be correct
- By the time the FED sees it, their reaction will be too little too late
If the FED allows the yield curve to significantly invert, and I believe they will, the odds that “It is different this time” are extremely low. That may not mean recession 2006 as the delay is often 12 months or longer but the longer the FED goes without a pause, the quicker a significant inversion and the quicker a recession will both happen. Note too that Gross is hedging his bet with “perhaps”. I am however, for the time being anyway, willing to assume the FED keeps on tightening until there is a significant inversion as opposed to a mere flattening. One more hike ought to do it I would think. At any rate, I would rather be in a camp with Bill Gross on recessions and treasury yields than in camp with the rest of the world thinking “It’s Different This Time”.
Mike Shedlock / Mish/