“David Brown 05/02/2015 08:50

“Just to add a couple of points to those that David’s listed in response to Crispin Odey’s gloominess. 

“The recession of 2008-9 was preceded by deep and sustained negative yield curves of all durations:
January 3, 2006 - March 29, 2006 (10yr - 2yr; and 10 - 1yr)
January 17, 2006 - March 29, 2006 (10yr - 6m)
June 2, 2006 - May 29, 2007 (10yr - 6m)
June 1, 2006 - June 5,2007 (10yr - 1yr)
June 8, 2006 - March 20, 2007 (10yr - 2yr)
July 31, 2006 - May 30, 2007 (10yr - 3m)
July 23 - all negative again for a few weeks till early August.

“Negative yield curves have heralded all recessions and market falls over the past half century or more, with a lag time of 0-24 months. We have not seen negative yield curves since 2006.

“The yield curve normally works as a predictor of recessions because, when the curve is steeply positive, bank lending is high and supports demand for credit, prompting the economy to recover and prosper. When the yield curve inverts, short term rates rise, raising the price of credit and discouraging lending and growth.

“However, one caveat: sometimes, even with a steep curve, bank lending may not rise and demand for credit may remain weak. The yield curve argument is therefore not applicable in this case. In 1937 the curve was positive yet there was economic recession and markets fell. Neither demand nor supply was able to stimulate the economy. This may occur, for example, if banks need to repair their balance sheets. To some extent we have seen this in recent years, though US banks appear in rude health again, European banks rather less so.

“So, if using the yield curve as an indicator, I suggest that we must also check whether credit is growing and flowing into the economy. 

“Another factor may be currency strength. A strengthening US economy and US dollar will likely attract capital flow into US assets including the stock market.

“Money goes where it is treated best. In the end, it is all determined by capital flows.” 

David Fuller's view

Many thanks for this excellent and educational email, the two middle paragraphs of which I have emboldened for emphasis.

It has been quite a while since I commented on the US Yield Curve, shown here on a 20-year chart.  It is an excellent lead indicator and the bearish danger signs start flashing when it moves below zero on the scale, indicating that 2-year rates have exceeded 10-year rates, creating a negative yield curve.  You can see that we are nowhere near that level today, although QE helped to bring the spread down from above 2.5%. 

When we next see the US yield curve below zero for more than a blip, I will regard that, as will many other observers, as a lead indicator that the US economy is within a year or two of recession.  The biggest problem in working with the yield curve is that the lead time can vary considerably, as you can see from 2006, well before the economic collapse of 2008.  For that reason the spike in crude oil proved to be a more precise timing indicator.  Nevertheless, I would much prefer to have leading rather than lagging indicators.

I agree that US banks have cash to lend, although I am not sure about the “rude health” mentioned above.  QE has also distorted rates, making loans less profitable.  More seriously, and perhaps this was an inevitable self-inflicted wound, rash lending up until the 2008 crash has been followed by what now seems to be overly zealous banking regulation.  Moreover, the Obama administration has treated banks like milch cows, fining some of them repeatedly and very heavily.  This does not help the lending clause. 

Nevertheless, most US corporations are not short of cash and many have benefitted by issuing long-dated bonds at very favourable interest rates.  Europe’s bonds are certainly more questionable but QE will obviously help.  This is also the case in Japan.  India’s banks are healthy and China’s have plenty of reserves – see Wednesday’s lead article: China Easing Seen as Just the Beginning by Ammunition-Rich PBOC.

Lastly, throughout my career I have learned that some of the most interesting and experienced people in terms of markets come from outside the financial industry itself.  David Brown is certainly one of them and I believe subscribers would enjoy the opportunity to meet him and hear his presentation at the Markets Now Seminar on 23^rd February.