Tuesday, June 5, 2012

Recession Within a Recession

Events in Europe appear to be causing unrest in markets.  Again.  Or perhaps reflecting unrest, depending on your point of view.  Things have been rather bad for some time, but they may be setting themselves up for another fairly dramatic plunge.

Everyone notices the various stock indices falling, but several things in particular point to a bad round of things in the short term.

The first is a flattening yield curve, and especially a drop in long-term rates.  Lending rates are determined primarily by two forces -- 1) supply of savings, and 2) demand for loans.  At the onset of recession, rates tend to drop, but in particular, long-term rates tend to drop dramatically as businesses fear making new long-term investments.  Meanwhile, some demand persists for shorter-term credit as businesses try to wrap up whatever they have going on at the moment.

On the flipside, lenders tend to pile on to the long end of the curve to lock in a higher interest rate and avoid short-term lending because they fear being forced to roll over the shorter-term loan at an even lower rate in the near future.  Together, the two groups wind up working at cross-purposes on the loan market, and lending terms tend to 'invert,' with short-term rates sometimes actually higher than long-term rates.  Sometimes it does not quite get to that point, and with short-term rates as low as they are now, and demand in general as low as it is, it would be rather difficult for them to invert at this point.  But the curve is definitely flattening.

The second big thing is falling factor prices, and as anyone who drives a car has noticed, oil prices have been falling pretty rapidly -- from about $105 per barrel about a month ago to about $85 today.  Some of this is due to new supply, as 'hydraulic fracking' technology has taken off of late.  But that has been going on for some time, and surely cannot account for such a rapid movement.  Many other commodity prices are falling as well, and if employment continues to stagnate as badly as the last labor report indicated, wages will eventually drop, too.

Several times since the 2008 crisis, I have thought that we were entering into another deep drop, but each time it has proved to be less dramatic than I had thought.  I do think that when all the dust settles and all the revisions are in, another small event will be declared in the 2010-2011 period which did not quite register enough to be called an official recession.  It is hard to say if this event will prove particularly more significant or not.

But eventually, 'the big one' will come...

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