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The Monthly Banker: 26 October 2006
US Federal Reserve keeps rates steady......................       
    
 
The month of October weighs heavily on the collective psyche of the stock market as if somehow protesting at being demoted to being the 10th month in Gregory’s calendar, rather than the eighth month that its name suggests.
 
Superficially the portents for this October aren’t that good either.  Even as I write the Dow Jones Industrial Average is bettering its all-time historical high, despite growing talk of a major economic slowdown in the US.
 
However, despite the Dow’s lofty level, equity valuations are not historically stretched and price/earnings ratios are broadly in line with their long-term averages.
 
Of further comfort is that the Fed appears minded to keep rates steady for now.  That is more than can be said for the Bank of England, which is altogether more hawkish, despite standing pat yesterday.
 
To understand why two such similar economies should have such differing monetary policy outlooks one need look no further than the local housing markets.
 
After a very minor slowdown last year, UK property price inflation is once again accelerating, squeezed higher by the enduring imbalance between supply and demand.  Luxury and large family homes are in particularly short supply in London, to the extent that the best examples increased in price by 2.2% in August alone.
 
By contrast, lack of supply is really not the issue in the US, so the slowdown has developed into a steeper slide in prices.  The price of the median home in the US is already 1.7% lower than it was a year ago.  The fall accelerated in August with the median price down by $5,000 to $225,000.  Rising inventories of unsold properties point to further price declines.  
 
This back of a fag packet analysis of the UK and US economies is necessarily somewhat limited.  Nevertheless it does indicate why short term rates are behaving so differently in countries which have so much in common economically.
 
This common ground has frequently led to the UK economy being described as “mid Atlantic”.  The term is particularly apt at the moment with ECB officials consistently out-hawking the Brits with their policy rhetoric.
 
Part of the reason for the ECB’s aggressive stance is that it is very much further behind the curve in terms of monetary accommodation.  Senior officials have at times been very candid about the need for higher rates with Nicholas Garganas recently observing that there was still a considerable degree of monetary accommodation in Europe, “which needs to be withdrawn”.  Few who listened to yesterday’s press conference following the ECB’s latest rate hike doubt that another will follow before the year is out.
 
Unfortunately for the ECB the reality of its situation is that the major eurozone economies are, or at least should be, tightening their fiscal belts, which will magnify the impact of rate hikes on economies that in truth have yet to demonstrate a capacity for consistent growth.
 
Germany’s “brave” decision to raise Value Added Tax by 3 percentage points next January may fill a fiscal hole, but may also put the kybosh on hopes for a sustained recovery, particularly if the US economy slips into recession next year.
 
Given these concerns, it therefore might actually help if we could quantify the risk of the US economy crunching into reverse.
 
There are analysts who maintain that the most reliable means of doing this is by studying the yield curve.  Ordinarily yield curves slope upwards from left to right, reflecting the time value of money, or investors’ liquidity preference.  Quite rightly investors expect that locking their money up for longer periods should attract higher returns.
 
Occasionally things don’t work out that way though: the current situation being a case in point.  The US Treasury curve is inverted such that the yield on 3-month Treasury Bills is some 30 bps (or 0.3 of a percentage point) higher than the yield on a 10-year Treasury Note.
 
 
Source: Bloomberg
 
Since each of the 6 recessions since 1970 has been preceded by yield curve inversions, it would appear that we should start hoarding tins of baked beans and shotgun cartridges and head for the hills.
 
However, before we start to pack our survival gear, it is worth noting a study carried out by analysts working for the Federal Reserve Bank of San Francisco.  The study extrapolated the risk of recession from the Treasury market’s degree of inversion. 
 
Crunching the numbers suggests that the recession risk is currently no greater than 35%.  Clearly this is potentially bad news if you’re a marginal employee, but for most of the working population, recession is more of a possibility than a probability.
 
Looking more closely at the data is even more encouraging as there are times when curve inversions have not led to a recession.  This scenario typically occurs when there is some sort of artificial distortion in the Treasury market.
 
In the UK the gilt curve has been inverted on and off for the past few years without ever seriously threatening to tip the economy into recession.  The curve’s inversion is largely a function of the post-Maxwellian pension accounting regime, which insists that any mismatch between a company’s pension fund assets and liabilities be reflected in its bottom line.  Thus a huge profit in the production and sale of widgets can be wiped out at a stroke by an adverse movement in the value of a company’s pension pot.  This can have upsetting consequences for shareholders.
 
The way to avoid this is by closely matching your assets and your liabilities, which invariably means buying longer term bonds, the income from which equates to your commitments to your past, present and future employees.
 
US regulators are a little behind the UK in this respect, but they’re getting there.  The upshot is that pension liability driven demand for longer dated assets has been building steadily in the US, first flattening and then inverting the Treasury yield curve.
 
For sure this is not the only dynamic at play, but it is reasonable to assume that it explains at least part of the curve’s inversion and, by extension, reduces its recession-significance.
 
So, even if you believe in the yield curve’s power to predict the economy, the likelihood is that the probability of the US economy entering a recession next year (in the absence of a calamitous policy mistake by the Fed) is significantly below 35%.  Exactly how much below though is impossible to tell.
 
So this brings us back to the stock market and October.  Not a lot of people know that the Finnish name for October is lokakuu, which means “the month of dirt”.  With recession a mere possibility rather than a ranking probability, and equity valuations undemanding to boot, October’s dirt could well be of the “pay dirt” variety, rather than the brown smelly stuff.