The Best Recession-Forecasting Tool There Is
This is my December, 2001 report on the inverted yield curve. It looks as though it's in the pipeline again, as of November, 2005. If you want to be alerted the next time the inverted yield curve appears, subscribe to my free reports. To find out how, scroll to the end of this reprint.
Reality Check (December 3, 2001)
THE RECESSION IS HERE, OFFICIALLY
The U.S. government does not officially announce
recessions. It does not even define them. They are
defined -- very vaguely -- by a private research
organization, the National Bureau of Economic Research
(NBER). The NBER announces retroactively when the U.S.
economy entered a recession.
Officially, the NBER now says that the United States
went into recession last March. The barely positive
economic numbers that were released by the government from
March to October now mean, officially speaking, nothing.
The press has given very little publicity to the
NBER's recent announcement. For months, the press has done
whatever it could to keep from admitting the existence of
recession. The press has said, "It's not a recession yet.
Not really. Close, but no cigar. Keep on spending! Keep
that old devil recession away from our collective door!"
It was all bunk. We have been in a recession.
Now that the NBER has confirmed this, we get a new
slant. Here is an example from C/NET, the tech-oriented
Hooray, it's an official recession
By Larry Dignan
November 28, 2001
Well, folks, it's official; We're in a recession.
Now get out those party hats!
Why be happy just because a panel of
economists--also known as the National Bureau of
Economic Research (NBER)--has officially declared
a recession dating back to March? Because that
means the worst may be over, especially for the
tech sector, which showed signs of a recession
well before other industries went into a
When six sages from fancy universities tell you
what tech CEOs and their customers have been
saying for months, you know things are about to
turn up. The group has a tendency to be a little
late to declare a recession. . . . "Duh" is the
appropriate reaction to NBER's statement, which
surprised absolutely no one.
Oh, really? How many expert columnists in the major
media and the press have you read who have been maintaining
steadfastly that the U.S. economy has been in a recession?
I can't think of one. It sure wasn't on the financial TV
cable networks. The blow-dry commentators have been
begging, pleading with the public not to believe any such
thing. These people are professional cheerleaders who are
paid by the media to paint a happy face on the economy
because advertisers who pay the industry's salaries always
cut back on advertising budgets during recessions.
If the economists had listened to the
tech sector, it wouldn't have taken that long to
figure out a recession was in the making. In
April, just a few days after NBER said the
recession began, Cisco Systems CEO John Chambers
was already talking about the equivalent of the
100-year flood that whacked the
telecommunications sector. "The business
environment that our segment of the IT industry
is facing has never been more challenging,"
Chambers said at the time.
The tech sector's collapse was an easy call. I made
that call in February and March of 2000. I was virtually
alone at that point. The NASDAQ's peak came on March 10.
The collapse was accompanied by denials from the media that
it was a collapse -- all the way down. Finally came the
universal analysis: "The tech sector is not representative
of the economy as a whole. Its collapse was an aberration.
And, by they way, it's time to get back in!" The Party
Line has not changed.
After all that, the NBER speaks: "The
committee is satisfied that the total contraction
in the economy is sufficient to merit the
determination that a recession is underway."
Thanks for the memo, guys.
This C/NET report was written by some kid whose photo
indicates that he is about 30 years old. He is a graduate
of the Columbia School of Journalism. He makes it look as
though a panel of old fogy economists has only just figured
out that we are in a recession, so this just has to mean
that the recession is behind us. He does not give the
reader the benefit of the truth, namely, that the NBER
always announces recessions retroactively.
If the NBER did not make these retroactive calls, the
government and the financial press never would admit that
there is, was, or had been a recession. The NBER wisely
takes its time because the statistics that the government
releases are always slanted to the economic growth side.
Month after month, the government releases updates that
show that the growth rate was less than originally
reported. The NBER is slow to provide its retroactive
analysis because the government's statisticians are
unwilling, ever, to report the bad news the first time.
Now that the NBER has declared an
official recession, the economy is bound to come
back. At the very least, NBER's proclamation
should give battered tech investors new reason
for hope that help is finally at
It's always the same: (1) We're not in a recession.
It's a good time to buy stocks. (2) We were in a
recession, but now it's over or just about over. It's a
good time to buy stocks.
Then when is it a good time to sell stocks? Never.
In contrast, for someone who is willing to acknowledge
the economic facts, when is it a good time to buy stocks?
(1) At the bottom of a market. (2) Whenever special
situations occur, and someone who knows what he (or she) is
doing spots this before most investors do.
HOW WAS I ABLE TO FORESEE THIS RECESSION?
What I'm about to present, I present in order to alert
you to the obvious: if the experts understood Austrian
economic theory, and if they were willing to predict the
market and the economy in terms of this theory, they would
have offered a warning to get out of stocks in early 2000.
This was not a hard call to make. That's why I made it.
My secret was in recognizing the arrival of the
inverted yield curve. It is the most reliable recession-
forecasting tool that there is.
In the February, 2000, issue of my subscription-based
newsletter, REMNANT REVIEW, I ended with this warning:
Tight money will produce rising
short-term interest rates. Beware the inverted
yield curve, when 90-day T-bills command a higher
rate than 30-year U.S. bonds. This is a classic
indicator of recession. It's not here yet, but
10-year bond rates have moved higher than 30-year
rates. To "fight the tape" of the stock indexes
is risky, but the general movement of
conventional stocks is down. There will be a
rebound of the conventional stocks to match the
bubble.com stocks, or a fall in the latter. I
think the bubble will burst.
In the March 3 issue, released a week before the peak
of the NASDAQ index on March 10 (5040), I wrote:
The inverted yield curve occurs
late in economic expansions. Inflationary
pressures build. Long-term rates go up. Lenders
demand an inflation premium in the rate, so as
not to lose purchasing power. Then, in
expectation of an economic slowdown, long rates
fall. Borrowers must fund projects in order to
complete them, so they borrow short-term money.
This creates the inverted yield curve.
A pure inverted yield curve is not here yet:
90-day T-bill rate above the 30-year bond rate.
But there are signs that it is on its way. The
money supply is being shrunk. This means less
inflation; hence, a lower rate for long bonds.
It also means tighter credit, i.e., higher short-
term rates. The FED is slowly raising the
federal funds rate, the rate at which banks lend
to each other.
The other factor that convinced me that the end was in
sight for the NASDAQ was a price/earnings ratio in
December, 1999, over 206. A buyer had to spend $206 to buy
one dollar in earnings -- and not all of this profit would
be sent to him as dividends. This was an easy call.
Then where was the conventional financial press? On
the sidelines, as always, cheering on buyers who were then
buying CISCO (every portfolio advisor's favorite) at $70 a
share. Today, it's about $20. In the April 5, 2000 issue
of REMNANT REVIEW, I asked rhetorically: "Is Cisco
One of the most popular Internet
companies to buy is Cisco Systems. It sells
hardware for the Internet. There is no doubt
that it is a company with a huge growth
potential. It is growing 2.5 times faster than
Microsoft is. But investors pay for that widely
perceived potential. The P/E ratio is around
200. There is no dividend. It has a market
capitalization of over half a trillion dollars --
three times larger than Dell Computer, and over
two times larger than IBM, which has a P/E of 30.
It is now larger than Microsoft. Am I to believe
that Cisco Systems is a better buy than IBM?
Why would anyone buy this company's stock?
Not for dividends, certainly. Not because it is
an unknown firm, ready for some spectacular move.
Maybe someone would buy it because of the greater
fool theory: someone else may buy it later for
more money. But, eventually, the greatest fool
appears. The game ends.
The game indeed ended within a few weeks. Cisco
should have been in nobody's portfolio in April, 2000.
That stock was an accident waiting to happen. But the
experts didn't see the obvious.
I began predicting the recession in this newsletter in
Issue #55 (October 3, 2000). I based my prediction on the
arrival in July of a pure inverted yield curve: the
interest rate on 90-day T-bills was above the rate for 30-
year T-bonds. By October, the inversion was no longer a
I reprinted part of a 1989 promotion piece for my
subscription-based newsletter, REMNANT REVIEW, in which I
predicted a recession, based on this same indicator. That
recession hit in 1990. Here is what I wrote in REMNANT
REVIEW (December 1, 2000). I cited the work of economist
and forecasting master James F. Smith.
* * * * * * * *
Meanwhile, the inverted yield curve is till in force.
The 90-day T-bill rate is still higher than the 30-year T-
bond rate. Consider the warning of Professor James F.
Smith of the University of North Carolina's Kenan-Flagler
Business School. He is also the chief economist for the
National Association of Realtors. In January, 1999, the
Wall Street Journal named Dr. Smith the best overall
forecaster among professional economists in the United
States. This was the second time in three years that he
had received this honor. In the March, 2000 issue of the
UNC Business Forecast, Dr. Smith wrote the following:
. . . At some point in that process,
bond investors will bid up the prices of longer
term Treasury securities because they will be
convinced that future inflation will be much less
than current inflation. As that occurs, the
Treasury yield curve will become fully inverted.
My forecast is that that will happen in August
2001. If that comes true then you can be nearly
certain that just as night follows day and day
follows night, the next recession will arrive in
2002. . . . My forecast for that will not change
to any closer date unless we see a fully inverted
yield curve before August 2001.
In that case, you can just move the recession
date closer to the present by one month for each
month that the inverted yield curve appears
earlier than August 2001. For example, if the
yield curve became inverted in September 2000,
then the recession should arrive on June 16,
The yield curve went partially inverted in July: 90-
day rates over 10-year rates. It went fully inverted in
October, ten months ahead of Dr. Smith's forecast. If Dr.
Smith's forecast is correct -- and its highly specific date
indicates that he was exaggerating for comedy effect -- we
can expect a recession by the summer of 2001.
But how accurate has this indicator been in the past?
It is the most accurate recession-forecasting indicator
there is. Dr. Smith said this:
Whenever you see this relatively rare
phenomenon, which was last seen in 1989, and it
persists for one month or longer, you can be
virtually certain that the next recession will
occur within 10-15 months.
This signal has never occurred without being
followed by a recession since the creation of the
Federal Reserve System on December 24, 1913.
Conversely, the last time we had a recession in
the U.S. that was not preceded by an inverted
yield curve for U.S. Treasury securities was the
one that began on May 16, 1923 and ended on July
* * * * * * * *
Most of the financial commentators in the major news
media were completely unaware of this development in 2000.
The few who did comment on it dismissed it as irrelevant --
the most accurate recession-forecasting tool of all time.
They were wrong. Again.
They did not announce the arrival of the recession in
March. They are barely discussing it today. The focus is
now on Alan Greenspan, as usual.
The FED's increase in the money supply in order to
reduce short-term rates is the main policy tool that it has
to reduce both the duration and intensity of a recession.
Its other policy tool -- very weak at this point -- is to
reduce reserve requirements for urban banks. It has not
Greenspan has been trying to get the yield curve as
positive as he can: short-term rates far below long-term
rates. But in recent weeks, the FED has put on the
monetary brakes. Look at the Adjusted Monetary Base, the
one statistic that the FED can control directly by either
buying or selling assets.
[November, 2005 update: This chart is now out of date. What it shows now is monetary tightening, which is creating the conditions for an inverted yield curve.]
Up until September 22, the monetary base was
skyrocketing. Then the FED revered course. Since October
3, there has been a 13% reduction -- quite large. Over the
last year, the increase has been over 8%, but the FED has
called this to a screeching halt.
What is the FED doing? Gyrating. It is trying to
avoid price inflation, yet it is also trying to inflate its
way out of the existing recession. The key question today
Will the FED's actions produce
Greenspan's goal, namely, to pull the U.S.
economy out of recession and also avoid price
My answer is simple: no. He has to decide: inflation
or recession. If the FED expands the money supply, this
will produce stagflation and, when the FED slows the rate
of monetary expansion, to another recession. We are now in
a situation like we were in 1980-81: either one long
recession or multiple recessions.
September 11 forced Greenspan's hand. He thought he
had to inflate massively in order to forestall bank runs.
You can see this in the chart: the spike. It is clear from
the contraction late September that he did not adopt this
expansionary policy as a counter to the recession, which
had been in force ever since March. This was a post-attack
monetary policy. Now the FED has reverted to a pre-
September 11 monetary policy. It has had to contract the
monetary base in order to return to the status quo ante.
If we can learn anything from the FED's reversal, it
is this: Greenspan is still worried more about price
inflation/stagflation than he is about the recession. He
is ready and willing to inflate the money supply, but not
at a rate high enough to trigger price inflation. He is
not willing to undermine the dollar for the sake of
overcoming the recession. The accent is on monetary
inflation, but he is unwilling to risk serious price
inflation. He is more willing to live with a mild
recession. He will adopt a stop/go policy of monetary
My conclusion: the days of ten-year economic booms are
over. So are the days of doubling your money in a third-
party managed stock market mutual fund.
The rest of the industrial world is in recession. In
Asia, apart from China, it's already an economic disaster.
Japan is a basket case. Its pump-priming, big-deficit,
Keynesian economic policies aren't working. Price
deflation is high and getting worse. Exports will put
pressure producers all over the world to keep prices down,
despite new money flowing into their respective economies.
The Japanese must export goods or fall into a full-scale
depression. They will aggressively cut prices, cut the
value of the yen by expanding the money supply further, and
export whatever they can. With Japan, it's export or die.
It's great for consumers who have money to spend, and
who are willing to buy. But there will be fewer of such
consumers in a month. The squeeze of American producers
has only just begun. So has the corporate profits
This recession is being driven by falling profits. It
is not being driven by reduced spending by consumers. To
forecast a recovery, a rational economist should forecast
rising profits. But it's hard to make a case for rising
profits in America today. Price-cutting exports from Asia
will increase as the Asian recession increases.
REFUSING TO FACE REALITY
The forecasting experts read each other's happy-face
analyses, and they think that their joint cheerleading
constitutes economic analysis. Warren Buffett keeps
warning them that the days of easy money in stocks are
over, yet the entire profession -- salaried -- shrugs off
his warning. "What does he know? He's just an old man,
locked into the old economy." A bunch of journalists whose
meager assets are tied up in their heavily mortgaged homes
and pension funds managed by people who can't beat the S&P
500 index dismiss the opinions of greatest stock market
investor of all time. It's ludicrous, and it's universal.
When I was a child, my mother read me the story of the
Little Engine That Could. At age three, I knew the story
was a fake. It has children looking forward to good things
to eat, and one of these good things is spinach. This was
obviously adult propaganda.
Well, it still goes on. Alan Greenspan is the little
engine that supposedly can. "I think I can, I think I
can," he declares, and all of the Senators and Congressmen
except for Ron Paul repeat the mantra. I think he can,
too: debase the currency. But this will take time.
Recessions are times of selling pressure. Those
people who need cash sell assets at steep discounts. The
auto industry is giving away money: 0% financing. The
housing market has peaked, and in some areas, prices are
falling. Yet the money supply is rising. How can this be?
The newly created money is flowing into near-cash
assets: short-term debt instruments. Interest rates are
falling for short-term debt instruments. Investors are
looking for safety.
The Dow Jones Industrial Average has not approached
its 2000 high of 11,700. Money from pension funds keeps
flowing into stocks, which has kept the bottom from falling
out of the market, but marginal stock buyers are on the
sidelines. They still don't trust this market, nor should
they. The P/E ratio is too high. The public's debt level
to disposable income is the highest on record. And another
statistic, the P/R ratio -- prices to retained earnings --
indicates that we have entered a decade or longer of low
stock market performance.
* * * * * * * * *
I will let my readers know when the inverted yield curve appears again, both in my free, twice-weekly newsletter and also in my free Gary North's Tip of the Week, which you can subscribe to in the box on the home page of this site. Click here: www.garynorth.com.
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