Daily Speculations

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James Sogi

The Next Recession

Alex Castaldo reported: "At a meeting in Boston recently Mr. R, chief economist of a blue blood investment bank, is said to have made dire predictions about the economy. The Twin Deficits will lead, first to a sharp fall in the dollar, and then because of the resulting rise in interest rates, to severe problems for U.S. borrowers, both public and private. A ``spectacular wave of bankruptcies'' is possible."

I believe some of Mr. R's arguments are not sound:

Smart people downtown agree.. (testimonial/bandwagon) You don't have to ask a Wall Street economist to know this, of course. Watch people wielding their credit cards this Christmas. (Plain folk) 30 percent chance of a slump soon and a 60 percent chance that we'll muddle through for a while. (non verifiable prediction) Consumers, who are in debt up to their eyeballs, (glittering generality) America has to import $2.6 billion in cash. Every working day. (card stacking) A source who heard the presentation concluded that a "spectacular wave of bankruptcies" is possible. (unattributed hearsay)

The real question is When is the next recession expected to arrive?

Yield curve is flattening still, especially short end, but not flat yet.

"A /flat/ yield curve frequently signals an economic slowdown. The curve typically flattens when the Federal Reserve raises interest rates to restrain a rapidly growing economy; short-term yields rise to reflect the rate hikes, while long-term rates fall as expectations of inflation moderate. A flat yield curve is unusual and typically indicates a transition to either an upward or downward slope. The flat U.S. Treasury yield curve in Figure 3 below signaled an economic slowdown prior to the recession of 1990-91.

*What are the different uses of the yield curve?* The yield curve provides a reference tool for comparing bond yields and maturities that can be used for several purposes.

First, the yield curve has an impressive record as a leading indicator of economic conditions, alerting investors to an imminent recession or signaling an economic upturn, as noted above.

Second, the yield curve can be used as a benchmark for pricing many other fixed-income securities. Because U.S. Treasury bonds have no perceived credit risk, most fixed-income securities, which do entail credit risk, are priced to yield more than Treasury bonds. For example, a three-year, high-quality corporate bond could be priced to yield 0.60%, or 60 basis points, more than the three-year Treasury bond. A three-year, high-yield bond could be valued 4% more than the comparable Treasury bond, or 400 basis points "over the curve."

Third, by anticipating movements in the yield curve, fixed-income managers can attempt to earn above-average returns on their bond portfolios. Several /yield curve strategies/ have been developed in an attempt to boost returns in different interest-rate environments."

James Sogi is a philosopher, Juris Doctor, surfer, trader, investor, musician, black belt, sailor, semi-centenarian. He lives on the mountain in Kona, Hawaii, with his family