Rickards: Fed's Looking In Wrong Direction

The Fed won't help you see the recession coming, so get ready for it.

What is the state of the economy? Every day, hundreds of economic indicators are released as either hard data or surveys of sentiment. It is possible to track broad trends using computers, charts and natural language processing. It is possible to use a lagging indicator to measure how bad the situation is, but by then it's too late to take any action to reverse its course. Indicators -- signs that appear six months or even a year in advance of trouble. The Federal Reserve is obsessed by lagging indicators for reasons that are unclear. It is partly because of this that they are always wrong with their policy. After recessions are already underway, they tighten the monetary policy and make them worse. Think of the 1929 stock market crash, the Tequila Crisis in 1994, the Russia/LTCM Crisis in 1998, the collapse of dot.com in 2000, and the 2007 mortgage bubble. The Fed's reading of economic indicators is prone to errors, especially when it comes to inflation and unemployment. Owners will only fire employees when these measures fail to stop bleeding. The business cycle has no relation to it. Early 1960s saw low inflation and high growth. In the late 1970s we experienced high inflation with weak growth. In the 1990s we experienced moderate inflation and high growth. Anyone see a connection? It doesn't exist. There is no correlation between growth and inflation. Inflation is bad. Deflation, however, is also bad. The reason for this will be discussed another time. It's sufficient to know for now that the Fed is clinging to two indicators with no predictive value. These are indicators that are behind. What are the indicators of what's to come? They are easy to find and have a proven track record as predictive analytic tools. These indicators are easily found and have a proven track record as analytic predictive tools. A yield curve can be a simple graph that shows the yields of similar instruments with different maturities. The U.S. Treasury Securities market is one of the most liquid and largest in the world. Normal yield curves are upward-sloping. This means that higher yields are associated with longer maturities. This makes sense. The Treasury yield curve has a steep inversion. The 10-year Treasury Note yields 3.57 percent, the 2-year Treasury Note yields 4.14 percent, and the 3-month Treasury Bill yields 5.03 per cent. Investors who accept lower yields for longer maturities are expecting yields to fall like a stone due to recession or worse. The 3-month bill will mature in three months. If rates fall to 2.00% in late 2008, the 4.14% yield of the 2-year bill will seem generous. Investors like this. It's a little esoteric but is an even more accurate indicator than the Treasury yield curvature. Investors can purchase futures contracts for these rates up to five years in advance, but the contracts of one to two years are most commonly traded. These contracts are priced in percentages of 100.00. The lower the price the higher the yield. (Because the discount is greater to 100.00, the return will be greater.) The June 2023 Eurodollar Futures Contract is currently priced at $94.5850. The contract for September is priced at 94.9650. Observe how the price increases over time. This means that markets are betting on a decline in short-term rates. This is another bet on a recession. The last time this inverted yield curve appeared was in 2007, and then again in 2008, just before the crash.

Treasury Securities dealers in the United States buy long-term bonds and finance them on overnight repo markets. Interest rate swap agreements can be used to make the same trade in derivative form. It's the same thing as owning a bond, but with two important differences: there is no bond; it is just a contract. Credit risk is accounted for by the swap payment, which is greater than the fixed rate on the bond itself. This is not the case anymore. The swap does not consume balance sheet capacity while the Treasury note does. Other technical monetary indicators also point in the direction of a recession. According to the most accurate predictive data, the recession will definitely come and could be already here. Prepare for the recession. Don't count on the Fed to warn you about it.