Long Term Economic Forecast

Economic Dashboard: Bonds, Inflation and Capital flows

The rapid economic expansion since 2003 has caused the Yield curve (white line) to rise rapidly to levels last seen in 1989 and 2000 just before economic contractions began. The contraction that started in 1989 was mild since the relative position of the US Dollar versus US Interest Rates (red line) was favorable and Inflation expections (blue line) were recovering. The next economic expansion that ended in 2000 was fueled by an exceptional "Goldilocks" combination of slowly rising Yield curve (white line) and declining Inflation expectations (blue line) mostly from a rising US Dollar from foreign Capital Inflows (red line). The contraction that followed the expansion of 2000 was severe, but not enough to significantly slow foreign Capital Inflows (red line) which kept long-term Rates low and started a sharp recovery into 2007 mostly from mortgages. According to the Yield Curve (white line) we are near the end of this economic expansion, and with high Inflation expectations like in 1987, and high Capital Inflows like in 2000, this coming contraction could be severe as well.

Bond Market Cash Flows - A strong economy causes the Yield curve to flatten (white line to rise) as earnings grow and extra cash flows to the Bond market, causing rates to drop and fueling the economic growth even more. As the Economy overheats and Inflation rises, the Fed raises rates causing the Yield curve to invert and the process to reverse with cash flowing out of the bond market to replace declining revenues from the economic contraction, causing rates to rise and aggravating the contraction even more.

Inflation Expectations - When Gold is stronger than Commodities (blue line declining), we have high Inflation expectations that should cause the Fed to raise rates to slow economic growth and keep inflation under control.

Capital Inflows - When the US Dollar is stronger than Rates (red line rising) it is suggestive of foreign inflows and supportive of US Assets.

Charts courtesy of StockCharts.com

Charts courtesy of StockCharts.com

The Yield Curve Inversion and the Fed pause add up to caution

Contrary to popular belief, Equities have already achieved most of their gains when the Fed stops raising Rates, especially when the Yield Curve goes inverted like we had in 2006. This can be seen in the corrections in Equities after the Fed paused in 1981, 1989, 2001 and now probably 2006. The reverse also applies, it is best to buy Equities after the Fed ends an aggressive Rate easing campaign that takes the Yield Curve well below the average 1-3% spread, like in 1982, 1987, 1992 and 2003.

Charts courtesy of StockCharts.com

Charts courtesy of StockCharts.com

Recession Watch

The Yield Curve inversion is widely known to have successfully predicted recessions and this over many decades. We have had a significant Yield Curve inversion in 2006 similar to the one in 2000, and both were stronger than the one in 1989. Since the last three Yield Curve inversions gave us recessions in 1981, 1990 and 2001, many are watching this indicator and expecting a recession in the next 12 months. I have also discovered another good predictor of recessions, based on the correlation between Solar Sunspot and ouput cycles and the Volatility index (VIX) . Recessions almost always occur after extended periods of Volatility that disrupts normal functioning of the economy like in 1960, 1970, 1981, 1990 and 2001. The single exception was the 1974 recession which was probably a continuation of the one started in 1970. While this model predicts a recession will occur near 2013, another 1974 like recession near the low of the cycle is possible in 2008 according to the Yield Curve inversion in 2006.

Liquidity induced Bubble Watch

After the roaring Twenties took debt to 270% of GDP in an unsustainable way, the collapse of this debt led to the great Depression, WWII, and a distinct distrust of paper assets and debt. Debt levels then returned to a more manageable 150% of GDP before rising again, mostly from the growth of mortgages as the real estate and commodities bubble took hold in the late 1970's. When these real asset bubbles collapsed, much of the funds moved to the Nikkei forming another bubble and pushing the Yen sharply higher in the late 1980's. Once the Japanese bubble collapsed, funds flowed back to US and European markets fueling their rise in the late 1990's, and confirmed by the rising US Dollar. The ensuing US market collapse of 2000 sent the funds back into real assets like Commodities and Real Estate, but this time embracing even more debt and leverage to 350% of GDP. We have phenomenal growth of credit in absolute terms too, with US Treasuries and total credit both expanded 9-10 times since the first bubble formed 27 years ago. Since we are already seeing the first flight away from risky paper, history is likely to repeat itself, and 60% of this debt will be eventually wiped out mostly worthless in the next 5 to 15 years.

Charts courtesy of StockCharts.com


Charts courtesy of StockCharts.com