Seriously. We are weary of the endless and seemingly limitless wasting of ink by economists, Wall Street experts, financial writers, the general media, the Administration, and last, but by no means least, the Federal Reserve -- all professing to prognosticate what the economy will look like in 3 months, 3 weeks, 3 days, 3 minutes. The ability to see the forest for the trees is constricted by orders of magnitude because of the typhoon of empty and useless verbiage we are subjected to every waking hour by the media, the economics profession, Wall Street, and the FED. Rather than participate in, or even waste time critically assessing the possibilities of short-term forecasting, we prefer to look at the longer-term prospects. Not only are these predictable with a vastly higher degree of certainty than the near-term future, but they are MORE SIGNIFICANT, by orders of magnitude, to serious investors seeking to place investment decision-making within the context of a reasonably hypothesizable future economic environment.
The reason that we say economic predictions 12-18 months down the road can be made with a greater degree of reliability than near-term predictions is that an extremely reliable forecasting tool exists to accomplish the former. This of course is the structure of the yield curve. The relationship of interest rates to one another at different points along the maturity spectrum has historically demonstrated an unparalleled prescience in forecasting the overall state of the economy 12-18 months down the road. Simply put, a normal, upward-sloping curve, where interest rates get higher the further out on the maturity spectrum you go, is predictive of an economy which will be growing. The STEEPNESS of the curve is a very reliable LEADING INDICATOR of the degree of growth one can reasonably expect a year or two in the future.
What is the curve telling us today, about the state of the economy in mid-late 2009? Although the curve is slightly inverted at the front end (more about this in a moment), the slope from 2 years to 30 years is entirely normal. The modest degree of the upward slope suggests an economy marked by modest growth at that time. The only fly in the ointment is the inversion at the front (with the FED-controlled overnight rate trading at 120 basis points ABOVE the 2-year BILL yield and slightly above the yield on all maturities up to 10 years or so, and with the 3- and 6- month bill yields slightly above the 2-year note yield but below the 5-Year note and all further maturities).
The one real cause for concern is, of course, the FED. The FED continues to hold the overnight rate far above the level the bond market is calling for. The overnight rate artificially raises short-term bill yields. Thus, the FED is continuing to prevent a FULL NORMALIZATION of the yield curve. Until the FED yields to the bond market, the prospects for growth in mid-late 2009 will remain very muted. However, we remain confident that a combination of pressures -- from the financial markets, from the political world, from the housing sector, and, most significantly, from an at-risk banking system -- will force the FED to allow the curve to normalize.
A serious and prolonged economic recession, extending well into 2009, is consequently very unlikely, in our judgment. The implications for equity investment and corporate profitability are favorable, provided individual security selection is competent. Whatever bumps may occur in the equity market, they will not likely prove severe overall, barring some currently unforeseeable economic catastrophe or the onset of collective insanity at the central bank.
