What is the probability of a U.S. recession in the next 12 months?

Knowing how poor the central banks have been at forecasting economic indicators, and having analysed the IMF’s wild forecasts, we think that it makes sense to take consensus views with a large grain of salt. However, there is a substantial body of empirical evidence that has emerged since the 1980s that suggests that the bond market is a pretty good predictor of real economic activity.

It has been proven that the slope of the yield curve has had a consistent negative relationship with economic activity in the U.S., with a lead time of around 1-1.5 years. By analysing the difference between 10-year and 3-month Treasury rates (also known as the treasury yield-curve spread), it is possible to calculate the probability of a recession in the U.S. in the coming 12 months. The theory goes that a monetary tightening will increase short-term rates, resulting in a flat (or inverted) yield curve as the economy slows and demand for credit falls. Additionally, inflation expectations may also fall at this time.

Research has shown that the yield curve has predicted essentially every U.S. recession since 1950 with only one “false” signal, which preceded the credit crunch and slowdown in production in 1967. This is shown in the chart below. There is also evidence that the predictive relationships exist in other countries, such as Germany and the United Kingdom.

The yield curve is a good recession predictor

Having established the predictive power of the yield curve, economists naturally wanted to assess what the yield curve was telling us about the probability of recession going forward. In 1996, economists from the Federal Reserve Bank of New York estimated the likelihood of recession based on the yield-curve spread.

Helpfully, the Federal Reserve Bank of New York updates its research on a regular basis. So what probability of recession in the next 12 months is the bond market currently pricing in? The answer is 5.38% to be precise (this is probably lower than it should be due to the Fed embarking on a record amount of quantitative easing).

5.38% chance of U.S. recession in the coming 12 months

Some economists swear by the predictive power of the yield curve. Others argue the yield curve has lost some of it predictive power due to other factors that are driving the longer end of the yield curve; such as quantitative easing, currency pegs to the U.S. dollar, and regulations. However, the simple rule of thumb that the difference between ten-year and three-month Treasury rates turns negative in advance of recessions is still reliable, with negative values observed before the 1990-1991, 2001 and 2008 recessions. Perhaps Alan Greenspan’s “conundrum” of low long-term interest rates wasn’t due to what Ben Bernanke termed as a “global savings glut”. Rather, the yield curve was telling us that the chances of recession were rising, and this is reflected in the increase in the probability of recession from 4.5% in January 2006 to 38% in January 2008.

The yield curve remains a great tool for investors. Its power to predict recessions cannot be ignored, so beware if it inverts again.

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If this is part 2 of the Great Recession, what were the 10 recent policy errors that got us here?

When it was all academic, I enjoyed reading about the causes of the Wall Street Crash, the Great Depression and the German hyper-inflation.  Policy errors abounded. The UK going back on to the Gold Standard in the middle of the crisis and sending the economy down in to a deflationary spiral.  Andrew Mellon, US Treasury Secretary, saying “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate…it will purge the rottenness out of the system” (and letting the banks go bust).  France demanding punitive war reparations from a desperately weak Germany, causing money printing and social unrest.

So if what we’re seeing right now is the start of a second wave of the Great Recession, what will historians think were the big policy mistakes in the couple of years since the first down-wave ended in 2009?  Here are a few ideas – the 10 recent policy errors that have sent us back to the brink:

1. The ECB hiking interest rates twice this year in response to a commodity led inflation overshoot.  Whilst I guess this gets reversed next month (or even sooner?) and the ECB cuts, the damage this did to confidence and to European funding costs was significant, not least because it caused the Euro to remain relatively strong.  There was no evidence of second round inflationary effects, and the hikes came at a terrible time in the recovery.

2. The Tea Party and the idiots on both sides of politics in the US not coming up with even small compromises that would have given S&P an excuse not to downgrade the US from AAA.

3. The continuing Osborne UK austerity programme.  As economic growth deteriorated, as youth unemployment rocketed and as confidence collapsed, he announced there was no Plan B.  “Liquidate, liquidate, liquidate”, as Mr Mellon might have said, applauding.

4. Not banning shorting via sovereign CDS.  We like CDS, we use CDS.  But if they didn’t exist, the ECB could have aggressively bought peripheral European bonds and driven their yields down.  Nowadays, whilst they were doing this in the physical bond market, the market was signalling its disbelief via wider CDS spreads.  This visible secondary market doesn’t allow anyone to suspend disbelief.  The price action in sovereign CDS dominates sentiment – just take a look on Twitter.

5. Over-regulation of the banking sector.  I’m not sure about this one, because the banks are evil, right?  But the backdrop of Dodd-Frank in the US, the global solvency regulations and Basel 3, the ring fencing of retail/investment banking etc. doesn’t provide an environment in which bank lending will aggressively recover.  That’s if you think more bank lending/leverage in the system is a solution to this mess.

6. Not bailing out Greece/not letting Greece go bust quickly.  It kind of didn’t matter which, but one of them could have saved the Eurozone.  Greece started to wobble at the end of 2009, so we’ve had nearly 2 years of sovereign debt uncertainty now.  Incidentally, could you compare the clamour for austerity for the Greeks now, to the French demands for implausible payments from Germany after the first world war?

7. Doing the wrong kind of Quantitative Easing. Operation Twist? The Fed needed to inject printed money directly into a broken housing market and underwater mortgages, boosting labour mobility and getting cash to those with a high marginal propensity to consume, rather than giving the printed money to investors in assets who didn’t do anything with it.  QE needed to look a little more fiscal than monetary.

8. China’s pegging of the RMB to the US dollar, and the consequence of many other countries having a semi peg to the US dollar in order to remain competitive versus China.  Currency wars.  The RMB is the wrong price – it’s artificially too weak and therefore developed countries’ currencies are artificially too strong.  This led to a race to the bottom to weaken relative to other economies, and that didn’t help anyone.

9. There was a brief moment in the quiet year or so that we had, when UK defined benefit pension funds were pretty much fully funded for the first time in years.  They could have de-risked and locked in benefits for their members.  Now that equity markets are nearly 20% lower, and bond yields have fallen by 1.5% (meaning assets have fallen, and liabilities risen) that’s no longer the case.  Pension funds didn’t de-risk in the good times, and left millions of workers and pensioners in peril for the future.

10. Not enough shock and awe.  Policy was always too incremental.  The world economy needed huge injections of monetary stimulus and fiscal stimulus.  The policy announcements were never enough, and confidence in policy making itself faded away as time went on.  Obama would like to extend a tax cut, the Fed will do something to do with the shape of the yield curve, the ECB will buy a few Portuguese bonds, the Bank of England might print £50 billion more.  The policy action was too tentative – and there wasn’t enough collaboration between policy-makers across the world.

I’m sure you’ll disagree, or have other policy errors to add.  If so, you can comment below, or tweet me @bondvigilantes.


The US is headed for recession – if 63 years of economic data are any guide to the future

Think the US is out of the woods now that congress has come to an agreement on the debt ceiling? Not according to this chart from Rich Yamarone, an economist at Bloomberg. It’s called the “2 percent rule”. When US GDP falls below 2%, it usually means the world’s largest economy is headed for a recession.

Last week, we received confirmation that US GDP was just 1.6% in Q2 2011. Combined with yesterday’s much weaker than expected ISM report and an unemployment rate at 9.2% , it suggests that the US Federal Reserve won’t be in any rush to hike interest rates this year. Fed Governor Ben Bernanke may even be warming up the printing press (as Mike alluded to here) if US employment and growth outcomes don’t start to improve – and quickly.

A Nobel aim – to find the right match and reduce the poison of long term unemployment

Hi everyone, I’m the new guy onboard. I started at M&G last week but the rest of the team is already working really hard to find me a ridiculous nickname.

Yesterday morning, I saw a familiar face in the news. My macroeconomics professor at LSE, Christopher Pissarides, had just won the Nobel Prize in economic sciences (jointly with Dale Mortensen and Peter Diamond). On top of being an exceptional scholar, I have to say that he is also a very good teacher and a very humble and approachable person, sometimes laughing at his own basic arithmetic mistakes while lecturing.

The search and matching theory that the laureates developed models how we end up with outcomes where unemployement persists even though there are job seekers willing to work for a wage that employers are willing to pay.

This theory on the frictions in labour markets is of particular interest in today’s economic environment. The post-recession unemployment rate in the US (9.6%) and the EU (10%) shows little sign of improvement and raises concerns about the speed of recovery.  As Carmen and Vincent Reinhardt pointed out in their research looking at historical slowdowns, in the decade after an economic crisis in a developed country, growth remains lower and unemployement higher than its pre-crisis level. This implies that part of the cyclical components of the recession becomes structural.

The centre piece of the search and matching model, the matching function, intuitively suggests that if the duration of unemployment is large there will be more mismatching in the labor market:

M = m . U n. V n-1

Where M is the number of matches, U is the number of unemployed workers, V the number of vacancies and m and n are constants. Note that m has a negative relationship with the duration of unemployment (falling when the average duration of unemployment rises).

This leads us to think about the problem of the duration of unemployment, which has risen dramatically since the beginning of the crisis, from an average of 17.3 weeks in December 2007 to 41.7 weeks in September 2010.

The central message Pissarides shared with the world on the day he received the Noble prize is clear: “One of the key things we found is that it is important to make sure that people do not stay unemployed too long”.

Long term unemployment is one of the major factors explaining the persistance in the unemployment rate as workers lose their skills and knowledge, and above all their motivation. Pissarides argues that government subsidies should be used to help companies to hire people back and benefits should be accompanied with conditions that encourage people to find a job much quicker. These policies may help to reduce the so called frictions. The Fed is aware that QE is too blunt an instrument to directly address current employment distortions – but with no political consensus for fiscal action, I fear that Pissarides’s message will go unheard. In other developed economies, austerity measures are likely to include cuts in government subsidies rather than increases, which risks letting unemployment become entrenched.


A letter from Ireland to M&G’s Bond Vigilantes

Dear Bond Vigilantes,

The small nation of Ireland has received more than its fair share of press since the credit crunch started three years ago. The financial crisis has not been kind to the Irish economy, with the collapse of the Irish property bubble having a profound impact on citizen’s net wealth and psyche. In fact, Ireland was the first country in the EU to officially enter recession. As recently as this week, Standard & Poor’s downgraded Ireland’s credit rating to AA-, its lowest since 1995. The “Celtic Tiger” was shot and wounded when Lehman Brothers collapsed.

I had previously worked in Dublin from 2007 until mid 2009 and saw the effects first hand that the recession was having. Union strikes, vacant shop fronts and alarming headlines in the newspapers were becoming an all too regular occurrence. On one occasion, an estimated 500 people queued for 15 jobs at Londis, a convenience store chain. The line of people stretched from St. Stephen’s Green to halfway down Grafton Street. Things were truly dire, and an air of uncertainty was a constant presence in conversations with colleagues, friends and family.

With these memories fresh in my mind I headed back to Ireland with my brother and old man, with a view of sampling some of the Guinness and scenery. But first a bit of background.

The problems with the Irish economy are well known. So are the measures the Irish authorities have undertaken to consolidate the governments’ finances. Sizeable cuts to public sector pay and social welfare payments have helped to restore confidence amongst the global policy community and international financial markets. After a severe decline in growth in 2008 and 2009, the Irish economy has stabilised in 2010 and is now growing again.

But the path from crisis to stability and recovery is likely to be narrow and rocky. Ireland will likely rely on exports and tourism to lead the economic recovery. As Ireland is part of the European Economic and Monetary Union (EMU), they cannot rely on a depreciation of the euro in order to become internationally competitive. The Irish need to become more productive and have to reduce wage costs. Irish banks remain a source of uncertainty with higher than expected losses, uncertainties in global regulatory trends, and limited access to funding hurting the Irish financial system.

As we travelled around Ireland, speaking to the locals, drinking with the locals, having the craic with the locals, the state of the economy would often come up. In these chats, a few themes kept re-occurring. These themes were unemployment, emigration, house prices, and the banks.

The unemployment rate in Ireland deteriorated from 4.5% in 2007 to 13.0% in 2010. This large increase in unemployment reflects significant structural changes in the Irish economy. Unsurprisingly, the construction sector was a huge employer of people in Ireland and with the house price crash it is unlikely that these jobs will come back. Looking at the unemployment data in Ireland, it is a concern that labor participation has fallen among older males as they may find it increasingly difficult to find work in the future as the economy recovers. Persistent unemployment is going to be a huge challenge for the Irish authorities.

For the first time in many years, Ireland is experiencing net outward migration. In this downturn, immigrants from Central and Eastern Europe have left Ireland in droves, whilst the Irish themselves have emigrated to places like Australia, Canada and the UK. Without emigration, the IMF estimates that the unemployment rate could have been as much as 2 percentage points higher. The concern is that Ireland is experiencing a “brain-drain” (present company excluded), and the Irish education system is effectively exporting a highly skilled and educated workforce (one that will pay taxes in their new place of residence).

Driving through the towns of Ireland we often encountered huge estates of houses that had been completed to varying degrees. These have been named “ghost estates” by the Irish. House prices shot up in Ireland during the boom years but were also accompanied by a construction boom, leading to a rapid increase in the supply of available housing (as seen in the accompanying chart), new shopping centres, business parks, and hotel developments. The dependence on the property market as a key driver of the economy and a vital source of tax revenue during the “Celtic Tiger” years has left the country with a set of serious problems that may take a generation or more to resolve. Certainly banks have tightened lending for new construction projects markedly, and it appears that there is little need for any new houses to be built in the immediate future. Some commentators have gone so far as to say the ghost estates need to be knocked down.

The National Asset Management Agency (NAMA) was a constant source of topic on the radio and in the Irish newspapers. The Irish government set up NAMA to transfer distressed property developments from the books of banks into a “bad bank”.  By February 2011, NAMA will hold €81 billion of toxic debt which is roughly equal to 50% of Ireland’s GDP. The Irish have not bought into the idea of NAMA, with many suggesting that the losses incurred by the “cowboys” at the banks should not be offloaded onto the Irish taxpayer. Pure and simple NAMA is an experiment and only time will tell whether it was the right thing to do.

On the austerity measures that Ireland have introduced, I think a quote from The Daily Telegraph’s Ambrose Evans-Pritchard sums up the views of the Irish pretty well:

“Dublin has played by the book. It has taken pre-emptive steps to please the markets and the EU. It has done an IMF job without the IMF. Indeed, is has gone further than the IMF would have dared to go. It has imposed draconian austerity measures. The solidarity of the country has been remarkable. There have been no riots, and no terrorist threats. Yet as of today it is paying 5.48% to borrow for ten years, or near 8% in real terms once deflation is factored in. This is crippling and puts the country on an unsustainable debt trajectory if it lasts for long. Yet Greece is able to borrow from the EU at 5% and from the IMF at a staggered rate far below.”

It is particularly interesting if we think about the austerity measures that Ireland have had to implement and then try to determine what the possible impact that budget tightening might be on the UK and a major European country like Spain. Through assertive steps to tackle the budget problems head-on, Irish policymakers have gained significant credibility. But that is not enough. Retaining credibility will require strong commitment and active risk management. The markets view ambitious fiscal consolidation plans in Ireland, Spain and the UK as appropriate and these plans will demand years of tight budgetary control. If new governments are elected, will they continue to retain a tight control of government spending in the face of rising public discontent?

The return to a self-sustaining economic recovery, with lower levels of government expenditure, is going to take time in the respective economies. In the interim, unforeseen fiscal demands may occur and policymakers have limited bullets left in the fiscal gun. With limited fiscal resources, maintaining a steady policy course will be required to minimise risks and sustain market confidence. We saw that the market retained some confidence in Ireland during the Greek sovereign crisis in May, when CDS for other European peripheral nations widened relative to Ireland CDS.

More recently, CDS for European nations has been widening due to concerns about the ability of sovereigns to issue debt and a slowdown in the global economic recovery. CDS for the UK has been stable and confirms the market’s view that the UK is relatively risk free.

The Irish have a tough task on their hands, no doubt about it. The restaurants and pubs are quieter than they used to be and the price of a pint of Guinness has come down a little (around €3.80 on average at the pubs I visited). In many ways, the Irish authorities have done everything that was required of them and this is pleasing some market participants. Mike Riddell bought some Irish 10 year government bonds on Wednesday after Ireland was downgraded, reflecting his view that the authorities remain committed to austerity and that the bonds are attractive at these valuations. Irish 10 year government bonds are currently yielding 5.60% compared to 2.16% for German 10 year bunds. The spread of Irish government bonds to German bunds is currently 3.44% which is a record level, so investors that are willing to take more risk are being compensated well to do so. Interestingly, the ECB waded into the market and bought some Irish 10 year bonds as well on Wednesday.

There is also a lesson in Ireland’s experience for emerging market nations, particularly in Central and Eastern Europe. In the 1980s Ireland was a relatively poor, peripheral nation on the edge of Europe with a weak economy. Foreign direct investment was mainly in low-skilled, branch plant manufacturing. The 1990s saw Ireland transform to high-skilled manufacturing and the development of a domestic consumer society. By 2003, the OECD estimated that Ireland had the 4th highest GDP per capita in the world on purchasing power parity basis. Unit labour costs shot through the roof during this period, reducing Ireland’s competitiveness in export markets and leading to inflation that was usually above the EMU average. The departure of Dell, a large manufacturing employer, from Limerick to Poland was a signal that Ireland had lost its edge in low-end manufacturing. It is important governments and policymakers in emerging nations learn from Ireland’s mistakes.

Ireland will push through this crisis, but there are going to be some bumps along the way. And apart from analysing the state of the Irish economy in this letter, I’m also going to let you know what are “must-do’s” if you visit Ireland. Stay in a fishing village called Kinsale in County Cork. The Dingle Peninsula, Ring of Kerry and Aran Islands were also highlights on my week long journey. Have a few Guinness. Don’t have 10.

See you all soon,



Alistair Darling – a Chancellor who will go down in history (in a good way); and was Margaret Thatcher really a public sector axewoman?

Now that the new UK government is bedding in and getting ready to unleash austerity upon us, I thought I’d quickly look back at the last Labour government and tell you something that you won’t want to hear: the last Chancellor Alistair Darling did a very good job.

There were three significant tests given to him during his 3 year Chancellorship.  Of those, I think that two were passed with flying colours, and on the final test we’ll probably never know whether he was right or wrong.  The first test was the run on Northern Rock in September 2007.  This was the UK’s first bank run in 150 years (since Overend Gurney crashed in the 1860s causing 300 companies to fail) – and at the time both the Bank of England, obsessed with the concept of moral hazard, and the Conservative party, would have let the bank fail.  It’s sobering to look back at how close we came to a full scale run on the UK’s banking system at that time – and perhaps how close we would have come to civil meltdown had the ATMs stopped working.  Alistair Darling’s decision to support Northern Rock (and later the other major high street banks) was a game changer, and set a global precedent for the correct response to a run on a retail bank.

The second big game changer came a year later.  US Treasury Secretary Hank Paulson was desperate to find a buyer for Lehman Brothers, the failing US investment bank.  None of its US competitors would buy it without significant government support.  In Andrew Sorkin’s brilliant account of those times, Too Big To Fail (a must read) he recounts how Barclays were on the brink of buying Lehman – before a phone call from Alistair Darling made it clear that that would not be allowed to happen.  Andrew Sorkin claims that a furious Paulson said that “the British have grin-f*cked us” – and Lehman filed for bankruptcy by the end of the weekend.  We’ll never know whether Barclays buying Lehman Brothers would have lead to its downfall, and systemic implications for the UK banking system – but we do know that Barclays was subsequently able to buy the best bits of Lehmans out of bankruptcy for a song, without exposure to the toxic parts of the business.  If the US government was the seller, yet no US bank was a buyer despite having had unprecedented access to the Lehman books, it should have raised a lot of warning flags.  Again, a big call, and one that turned out to be the right one.

The final test was the decision to maintain fiscal stimulus for the UK throughout 2010, despite the widening budget deficits.  Thanks to the General Election result we’ll never know whether that would have been the right thing to do – certainly Keynesian economists like Paul Krugman are adamant that any contraction in government spending in the current fragile economic environment will be the trigger for a severe double-dip.  David Cameron today announced “painful” cuts ahead that will affect “our whole way of life”.  So the jury is out on this final big decision – Darling’s enemies will argue that the Labour government of which he was a key player was responsible for the exploding deficit in the first place.  Whilst he didn’t become Chancellor until 2007 when things had started to go bad, the New Labour project did loosen fiscal policy when times were good (and befuddled current spending with “investment”) giving deficits nowhere to go but up when the economy turned.  Much of this current deficit problem was baked in the cake thanks to our deteriorating demographics, or results from the correct decision to bail out the banks – but Labour’s pro-cyclical fiscal expansion must also take a share of the blame. 

I wonder how we’ll judge George Osborne’s Chancellorship when it comes to an end?  Whilst Nick Clegg has claimed there will be no return “to the savage cuts of the Thatcher years”, it’s interesting to note that apparently our “folk memory” of the Thatcher cuts is defective (according to a Stumbling and Mumbling blog post here).  Apparently the Thatcher government only cut public spending in one year, and froze it in another.  The blog’s author Chris Dillow suggests that the reason we all imagine there was a huge spending contraction in that Conservative government is because public spending grew at a slower rate than under the previous Labour government.  It’s certainly interesting that the incoming Conservative government will be far more aggressive with the spending axe than Thatcher ever was – and perhaps Mervyn King’s reported comments about the incoming government being out of power for a generation as a result of the austerity that they would implement isn’t far from the truth.  We’ll find out in 5 years’ time – if not sooner.


Unemployment likely to rise for many months to come – Central Banks firmly on hold, perhaps for over a year

With sovereign and political issues taking centre stage in markets recently, macroeconomic indicators have taken a back-seat in many market participants’ minds. But how have the advanced economies been recovering, absent these risks? Today I’d like to focus on some research on labour markets that was recently published by the International Monetary Fund (IMF) in their World Economic Outlook and the implications this might have on central bank interest rates.

Unemployment is a big problem at the moment and is a key challenge for policymakers globally. Strong labour markets generally result in higher consumption and wealth effects, generating higher standards of living and stronger GDP growth. Given this context, the IMF has sensibly asked: how long before employment recovers?

Sadly the employment reports to come out of the US, Europe and the UK have not made for comforting reading. In the US, the unemployment rate jumped to 9.9%, despite the fact that more jobs were created than in April than in any month in the past four years. In Europe, there are 23.1 million people out of work, and unemployment is still rising in 26 out of the 27 member states (the unemployment rate has fallen in Germany however, showing the unsynchronised nature of the economies within the Eurozone). Finally, the UK has 2.51 million people looking for a job – the highest level since December 1994. The UK unemployment rate, at 8 per cent, is at a level that has not been seen for sixteen years.

To help us assess the current state of labour markets in an historical context, the IMF has analysed unemployment developments in recessions and recoveries over the past 30 years in a number of advanced economies. Being economists, they have a rule to assist them in organising their analysis called Okun’s law. It’s basically the relationship between the unemployment rate and GDP. If the unemployment rate rises in a country, then its GDP will fall. If unemployment falls, GDP goes up. Pretty simple really. According to Andrew Abel and Ben Bernanke (Chairman of the U.S. Federal Reserve), estimates based on data from more recent years give about a 2% decrease in output for every 1% increase in unemployment.

The IMF has found that ‘the responsiveness of the unemployment rate to changes in output has increased over time for several advanced economies, due to less strict employment protection and greater use of temporary employment contracts’. The IMF suggests that Okun’s law – the responsiveness of the unemployment rate to changes in output – has increased over time. Labour markets are now suffering more in a downturn leading to higher unemployment levels, but in the upturn phase of the business cycle labour markets can improve quicker than they used to.

It’s an interesting analysis but the key findings for me are as follows. If we look at the chart by the IMF on the experience of the last 30 years the unemployment rate peaks 5 quarters after a “standard” recession, 6 quarters after a recession caused by a financial crisis, and 5.5 quarters after a recession caused by a house price bust.  Employment tends to trough before unemployment peaks except during recessions caused by financial crises. In these recessions employment troughs and unemployment peaks 6 quarters after the economy returns to positive growth.

The recent readings in unemployment and employment are consistent in these findings. Taking the US as an example, we saw a large number of jobs created in April yet the unemployment rate increased. Why was this the case? It is because the participation rate increased, meaning that more people were actively seeking work. This is what economists call the “encouraged worker effect” – people outside the workforce seeing the economy improve and deciding to actively look for a job.

The IMF analysis is important, as we now know that the US and Europe exited their respective recessions in Q3 2009; and the UK registered positive growth in Q4 2009. Based on the IMF conclusions we can reasonably assume that unemployment rates in the US, Europe and the UK are unlikely to peak until around Q1 or Q2 2011, suggesting a deteriorating labour market and high unemployment rates for the remainder of 2010. Additionally, as we know from our discussion of Okun’s law, the unemployment rate responds to positive growth. With current unemployment rates ranging from 8 to 10 per cent Okun’s law suggests that we need to see a 2% increase in output above trend growth (trend growth is estimated to be around 2-3% for the major economies) to see a 1% fall in the unemployment rate. Is this really going to happen anytime soon?

If we turn now to an analysis of when the Federal Reserve raises interest rates after a loosening phase of monetary policy, we can see in this chart that the Federal Reserve tends to hike interest rates around 8 months after a peak in the unemployment rate. Using this as a rough guide as to when the Federal Reserve might start to raise interest rates from their historical low levels, an interest rate hike by the Fed is now moved out to around Q4 2011. Current market pricing is for a rate hike from the Fed in 6 months time in around Q4 2010. This looks like it could be too early given the IMF and our own analysis of past recessions. What are the implications for global interest rates if the central bank of the United States doesn’t hike rates until Q4 2011?

The reason I have focussed on the US is because it arguably has the best economic growth outlook at the moment from a fundamental standpoint. Key leading indicators like business confidence, housing starts, consumer confidence and retail sales look like they are recovering and have largely been beating economists’ forecasts over the course of 2010. Given the US does not have the concerns that Europe currently does over sovereign risk or the political and budgetary concerns of the UK, it may be the case that the Federal Reserve leads the European Central Bank and the Bank of England in hiking interest rates from their current historically low levels.

I suspect that the central banks will want to make sure that the recovery is self-sustaining, as indicated by rising employment levels and falling unemployment rates. Central banks want to see labour markets improving before they risk killing off the economic recovery. Given below trend economic growth, the absence of wage pressures and the limited pricing power of corporations to pass through rising producer prices to consumers, it is unlikely that inflation will be an issue in the short-term.  In this type of environment I think that the Fed, ECB, and BoE will keep interest rates lower for longer than the market and economists currently expect.


UK unemployment lowest since the 1970s – watch it rise

The government’s official unemployment rate (which looks just at the number of people claiming benefits) stands at 2.5%, the lowest rate since 1975. The UK unemployment rate under the International Labour Organisation’s measure stands at a slightly more realistic 5.2%, which is higher that 2003-06, but still way below the long term historical average.

A widely held view is that the UK economy will be OK, because unemployment is low. This view is misplaced. History suggests that unemployment is a lagging indicator – that is, it’s one of the last things to turn in an economic slowdown. What has normally happened in the past is that house prices fall, then consumer spending falls (and economic growth therefore slows), then unemployment rises, and finally inflation starts to fall as spare capacity is created in the economy.

This graph (click to enlarge) shows what happened in the UK’s last recession. House prices are represented by the blue line, and we’ve looked at house price changes on a rolling 3 months (and annualised). UK unemployment is the red line, and is plotted against the right hand axis (inverted). Last time around, UK house prices started falling in mid- 1989, but unemployment didn’t start rising until mid-1990.

Unemployment is a lagging indicator because it takes companies a while to realise that the economy is slowing. Once companies realise this, it then takes them a while to lay people off. So if you want to get an idea of what’s going to happen to the UK economy (or indeed the US economy), look at the housing market, not the unemployment rate. Anyone who’s focusing on unemployment as a measure of the state of the economy is likely to be well behind the curve


US housing downturn worst since Great Depression – and getting worse

Investors are almost becoming blasé to dire US housing market data releases, but the reality is that things are getting worse and worse.

The monthly S&P/Case-Shiller figures that came out on Tuesday showed that the US housing market downturn is now more severe than the one that led to the US recession in 1991. As the chart shows (click the chart to enlarge), the S&P/Case-Shiller Index Composite-10 Index fell by 9.8% in the year to the end of December. In Q4, the index fell by 21.0% on an annualised basis. This index starts in 1987 – for a longer history, you need to look at indices such as the catchily-named ‘US New One Family Houses Sold Annual Median Year Over Year Price Change’. This index fell 15.1% in the year to the end of January, the biggest fall since records began in 1964.

The excess supply of houses in the market suggest US house prices will continue deflating. The number of US homes for sale rose 5.5% to 4.2 million in January – at the reported sales pace, this represents 10.3 months’ supply, just below the record set last October. The months’ supply of new homes on the market rose to 9.9, representing the largest housing stock overhang in the US since 1981. US house prices will continue falling until this overhang is significantly reduced.

This chart (click the chart to enlarge) shows that the months’ supply of new homes is a very good predictor of US recessions. When the months’ supply of new homes breaks above 7 months (as shown by the yellow line, inverted on the right hand axis), the economy goes into recession (blue line, left hand axis). A figure of around 10 months’ supply suggests the US is about to head into a nasty recession – worse than what we saw in 1991, more akin to 1974-5.

Ben Bernanke yesterday stated that US real GDP has ‘slowed sharply since the third quarter’, US consumer spending has ‘slowed significantly’ since the end of 2007, and that labour market conditions have ‘softened’. Furthermore, ‘the risks to this outlook remain to the downside…the housing market or labour market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further’. This is a clear indication that the Federal Reserve is prepared to lower interest rates further. The Bank of England now needs to act in a similar manner.