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Investment Strategy

The Consensus is Wrong

By Elliott H. Gue, on Feb. 11, 2016

Despite signs of softness in the US economy, the Bloomberg consensus estimate calls for gross domestic product (GDP) to grow by 2 percent to 2.5 percent this year, in line with last year’s 2.4 percent expansion. The hive mind also puts the odds of the US slipping into recession over the next 12 months at about 20 percent.

Comments from policymakers at the Federal Reserve suggest that the central bank subscribes to this consensus outlook, though some members of the Federal Open Market Committee have expressed concerns about hiking interest rates in the current environment.

The most recent issue of Capitalist Times Premium reiterated our pessimistic outlook and put the chances of the US sliding into recession by the first half of 2017 at more than 50 percent

Subsequent downside in equities and declining yields on long-term US government bonds suggest that the market sides with our outlook.

What caused this widening gulf in expectations?

Grading against the Curve

For one, the yield curve—or the yield spread between 10-year and three-month US Treasury securities—has yet to invert, a phenomenon that occurs when long-term borrowing costs are lower than near-term ones. Before every recession since 1950, the US yield curve has either or inverted or contracted to within a few basis points of zero less than one year.

At present, the yield curve’s slope stands at 1.41 percent, down from more than 2 percent at the start of the year, though still in positive territory.

(Click graph to enlarge.)Yield Curve

But this time, it is different: The Federal Reserve has kept interest rates near zero for an unprecedented period.

Although the European Central Bank, the Swiss National Bank and the Bank of Japan have cut their deposit rates to less than zero, these extreme measures can create significant challenges.

Financial institutions, for example, become reluctant to charge customers to hold money because that would encourage deposit flight. When it’s cheaper to hold money in cash than keep it at a bank, depositors may decide to take their capital into their own hands, destabilizing the banking industry—admittedly, an extreme example.

At a minimum, central banks face a much more difficult decision to cut rates from zero to negative 0.25 percent than reducing the benchmark borrowing rate to 0.75 percent from 1 percent. Monetary policymakers’ options become even more limited when interest rates enter negative territory.

In this age of extraordinarily accommodative monetary policy, an inverted yield curve is next to impossible; if three-month Treasury bonds yield zero percent, the current return on 10-year bonds issued by the US government would need to fall below zero—an inconceivable situation.

Japan’s short-term interest rates have hovered near zero since 1995. Prior to this inflection point, inverted or flat yield curves usually preceded sustained contractions in the island nation’s economy; thereafter, Japan has suffered four recessions without the yield curve flashing its traditional warning signal.

Since the 2007-09 financial crisis, several European nations have experienced a similar phenomenon.

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