Is the bond market flashing the recession sign? Should we care?

Neither I nor our firm makes high level calls on the economy.  We refrain from peering into our crystal ball in part because the best time to invest is often when the economic news and data are seemingly at their worst.  But that doesn’t mean we ignore economic sign-posts.  I found data for one such indicator – the steepness of the U.S. yield curve – courtesy of my friend and value investor Dr. Norman Rothery of www.StingyInvestor.com.

10-3 Treasury Spread

Five years ago, The Federal Reserve Bank of New York (aka New York Fed) published a paper examining how effective the bond market had been at predicting recessions in the U.S.    Specifically, the authors – Arturo Estrella and Frederic S Mishkin – focused on the yield spread between 10-year and 3-month U.S. Treasuries.  (The industry has long followed variations of this indicator.)

They reasoned that this spread is very useful to study for the direct information that can be observed from it – i.e. short rates are used as a policy tool to spur or slow growth – and for the information (beyond monetary policy) and expectations embedded in bond prices.

In short, Estrella and Mishkin found that when the 10-3 yield spread is wide, good economic times are more likely a year from now.  When the spread is very thin or negative, we’re more likely to be in a recession twelve months from today they said.

The New York Fed updates this data monthly.  As of the end of July, the model suggests that we’re unlikely to be in a recession by July 2012.  While yields have dropped this month, this model’s output is no different.  But there are reasons not to take this model too seriously, at least right now.

A few years ago, in response to the 2007-09 financial crisis, the Federal Reserve lowered short-term rates about as much as they could.  Today, the 3-month Treasury yield is effectively zero.  Since it’s been between zero and 25 basis points for nearly three years, this is one policy tool that has been unavailable.  Arguably, that neutralizes one of the arguments for assigning significance to this indicator.

Economy ≠ Investment Environment

In a recent conference call, portfolio manager David Taylor – one of our favourite money managers – nicely captured the state of the economy.  He opined that the economy is at a tipping point; where it might be equally likely to tip into recovery mode or to fall into a recession.  But virtually all of those that are in the recovery camp agree that economic growth will remain sluggish.

If the economy is indeed at this tipping point, the shape of the yield curve may not be a good economic indicator today.  However, there is a strong argument for not even trying to figure out the economy with too much precision.  In his Q2 2011 commentary, portfolio manager Geoff MacDonald wrote about his view that the economy will be slower for longer.  More importantly he doesn’t try to figure out whether we’ll be in a recession or not in 2011.  But he does acknowledge that the economy faces significant headwinds – which aren’t going away quickly.

It’s certainly possible that the current decline will tip over into official bear market territory.  But that shouldn’t be surprising since bear markets have historically been clustered.  More importantly, a bad economic environment does not equate to a bad investment environment.  An economy that looks to be in its darkest days often gives birth to terrific investment opportunities.  While we haven’t seen widespread indiscriminate selling of stocks – as in 2008 – many great opportunities have emerged.

When hunting for investment opportunities, MacDonald is happy to invest in businesses even if their growth prospects are low or moderate.  The key, he says, is not paying for the growth.  And there are many quality businesses today that are growing – and should continue to grow – but are priced for zero or negative growth.

If the markets continue heading south, the bargains will keep getting better – which will simply set the stage for more attractive subsequent returns.  While stocks aren’t dirt cheap on a broad asset class level like they were a few years ago.  Then, you could throw your money at virtually any stock or any stock fund or ETF and do extremely well.  It’s not that easy today.  But the individual opportunities that have emerged imply that today is a good time to buy stocks selectively.