What Are the Odds of a Double-Dip Recession?

I've always liked Peter Lynch's observation that:

There are 60,000 economists in the U.S., many of them employed full-time trying to forecast recessions and interest rates, and if they could do it successfully twice in a row, they'd all be millionaires by now. ... But, as far as I know, most of them are still gainfully employed, which ought to tell us something.

Painfully true, but this stops no one.

The current forecasting debate du jour is over the odds of a double-dip recession occurring in the next year. Reading reports, blogs, and presentations, I get the feeling that most forecasters put the odds of this happening at something like 25%. But a growing group of dissenters says this is hogwash, and put the odds of a double-dip occurring in 2011 at precisely 0.31%. Less than 1%.

Spread thick
This group points to the so-called Treasury spread model, which shows the spread between 10-year Treasury bonds and three-month Treasury bills. The narrower the spread, the higher the odds of a looming recession, and vice versa. Today's spread is historically wide, putting the odds of the economy falling back into recession at close to zero -- 0.31%, to be exact.

If this sounds like hokum, it's because it probably is. More on that in a second. First, it's fair to point out that the Treasury spread model actually has an extraordinary track record:

Source: Federal Reserve. Shaded areas = recessions. Current downturn not marked because duration is still debatable.


Source: Federal Reserve. Shaded areas = recessions. Current downturn not marked because duration is still debatable.

What this shows is clear: When short-term rates go above long-term rates (an inverted yield curve), a recession is imminent. When long-term rates are way above short-term rates (as they are now), happy days await.

On Tuesday, a paper by Investor Alert chief market strategist Richard Salsman made its way around the Web, concluding that the Treasury spread model's current reading is proof positive that double dipping is a long shot. In his own words:

There's only a single case of "double-dip recession" in modern U.S. history -- when the 16-month recession of 1981-1982 arrived only a year after the 7-month recession of 1980. But as usual, in the lead-up to every other U.S. recession since 1961, both ends of that "double dip" were preceded by a deliberate inversion of the yield curve by the Fed. Monetary policy brought short-term interest rates above long-term rates, which effectively reduces or eliminates the profit margin on financial intermediation, or the business of "borrowing short to lend long." ...

Today's yield-curve spread is quite wide (roughly 275 basis points), and although it is much narrower than it was just four months ago, it's certainly not negative – the prerequisite for recession. There won't be a U.S. recession in 2011, no matter how uneven is the journey to then.

I'm not so sure.

As Salsman rightly notes, an inverted yield curve pushes economies into recession because it cuts the profitability of lending. Banks react to this by curtailing loan-making, which slows everything down as credit contracts. Conversely, a wide yield curve makes lending profitable, so banks open their coffers, and the economy thrives as credit expands.

But what's going on today fits neither of those assumptions. The yield curve is wide, yet credit is barely moving, if not outright contracting. You see this in the M1 multiplier, in M2 growth, in consumer credit, in bank credit, and almost anywhere else credit can be found. Credit is going nowhere at a time the Treasury spread model says it should be exploding. That's why I'm hesitant to take its forecast with more than a fistful of salt.

Some of this credit lethargy has to do with banks like Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) cutting back as they shore up their own books. More importantly, consumers and businesses are generally unwilling to borrow; they're trying to dig themselves out of decades of debt accumulation. And there's reason to believe we're nowhere near the end of this process.

That's what's unique about this recession compared with downturns past: We can't rely on credit expansion to fuel the recovery. Today's credit market doesn't need an inverted yield curve to contract; it's happy to do it on its own terms, thank you very much.

But who's counting?
Forecasts of 25% odds of a double dip seem supremely more credible than 0.31%. But as an investor, I'm still inclined to shout, "Do we really care?" There are plenty of companies that will do well come downturn or not: Altria (NYSE: MO  ) , Verizon (NYSE: VZ  ) , and Annaly Capital (NYSE: NLY  ) , to name a few. These are high-dividend-paying companies whose businesses are mostly detached from economic dips. Rather than quibbling over the odds of the unknown, that's what I'd focus on.

Fool contributor Morgan Housel owns shares of Altria and Verizon. The Fool owns shares of Altria Group and Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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  • Report this Comment On August 19, 2010, at 5:59 PM, TMFMMTInvestor wrote:

    Morgan:

    (1) You ask, "What Are the Odds of a Double-Dip Recession?" I say the odds are zero; when did the first recession end?

    (2) Isn't the FRB's Z.I.R.P. putting artificial downward pressure on 3 month T-bills, thus defeating Salsman's above Treasury spread argument?

    Even with current Fed policy, though, spreads are narrowing...hardly a positive economic sign and not good for the big banks that continue to borrow at the Fed's discount window. Without a rally in the XLF/the big financials, it's hard to see how the broader US equity markets don't move lower.

    Best,

    Scott

  • Report this Comment On August 21, 2010, at 11:51 AM, burrowsx wrote:

    The real reason to expect a double-dip in the market is politics. Wall Street needs to punish Obama for financial reform. They continue to withhold funds from the consumer by refusing to renegotiate promptly underwater mortgages, even with federal subsidies available to do so. They continue to charge exorbitant interest rates on credit card balances despite historically low commercial interest rates. I look for an October dip, followed by a December thaw, no matter who wins the election.

  • Report this Comment On August 23, 2010, at 9:33 PM, DDHv wrote:

    http://www.businesscycle.com/resources

    is supposed to be a good predictor. When below -10% (four weeks now), a recession is imminent. Looking forward to finding out, since this was just recently located.

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