Dan Nevins on Yield Curve, Recession and Thin Air Spending Power

Wed, Sep 11, 2019 - 3:00pm

As markets flirt with fears of a recession, many point to the recent yield curve inversion as a telling sign that recession is imminent. Financial Sense Insider spoke with Daniel Nevins, a financial analyst, investment professional and behavioral economics researcher to get his take on current conditions.

See Dan Nevins on Why You Shouldn’t Get Too Bearish.

Anticipating Recession

Nevins developed what he calls his ‘thin-air spending power’ (TSP) indictor that references spending capacity in the economy that “essentially arises from thin air.” This includes new bank credit and spending, which have a meaningful role on the business cycle. Banks are allowed and even encouraged to create money from thin air, Nevins noted, which injects spending power directly into the economy. New bank credit is largely correlated with spending, Nevins stated, and is almost synonymous with nominal spending in the economy.

The second aspect of TSP comes from household investment portfolios. When the stock market jumps up rapidly, suddenly everyone is wealthier thus improving household spending capacity.

“These two factors don't measure any particular amount of activity in the real economy, but they are highly predictive with regard to activity in the real economy,” Nevins said. “Relative to yield curve inversions as a recession predictor, the TSP indicator is timelier. … Even more importantly, the correlation of TSP with the next period’s real spending is about twice as high as the yield curve slope.”

Indicators Could Change in 2020

Based on what the TSP is showing, Nevins noted, his advice is to be patient. Though many forecasters are calling for a recession, the TSP has a good track record and is saying the economy will likely continue in expansion through at least 2020.

At some point in 2020, however, we may see financial and other indicators turn, but right now there is not much cause for concern. Rather than taking actions that depend on a recession occurring, Nevins recommends waiting to see those indicators shift before making a commitment.

The recent dip in ISM manufacturing indicator is certainly relevant, he noted, but manufacturing is a fairly small percentage of the U.S. economy, and the current movement may be part of a smaller cycle within the broader business cycle.

Currently, the TSP is not flashing a recessionary warning signal, Nevins noted. What he calls spending capacity, is also comprised of real household income and real business income. We have never had a recession that was not preceded by a fall in one of those measures of spending capacity.

“Banks are lending basically at an above average pace in 2019 so far,” Nevins said. “New bank credit is being extended and injected into the economy at a pace that's a little bit higher than what's average for the expansion. … If we see a stock market drop that is limited to 20 percent, then the TSP should continue to signal an expansion for the rest of this year, into early 2020.”

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TSP and the Yield Curve

The yield curve is important to watch, Nevins said, but it isn’t the final and all-important indicator some have made it out to be. It has produced false signals and its correlation with recession is based on a long lead time.

Yield curve inversions that historically precede recessions are part of a broader process including monetary policy and credit markets. When the curve inverted historically, it has always been part of a period of monetary policy tightening by the Fed. The Fed lifts policy interest rates, which anchor the short end of the yield curve, Nevins noted, and that increase in the short end brings it above the long end, which triggers an inversion.

The yield curve slope is a decent measure of monetary policy, he added, but it's not the only measure. And it may not be the most important measure. Another metric to examine is the difference between the Fed's policy rate and inflation, which arguably better captures the economics of what a change in monetary policy is doing to the economy.

“Historically, what you find is that in the lead up to recessions, the same Fed policy tightening that inverts the yield curve also tends to push the Fed funds rate above inflation by between three and five percent,” Nevins said. “During the current tightening cycle, the Fed only lifted the Fed funds rate to a premium over inflation of 0.9%. It's currently back to about 0.3% and falling. … My rule is that if you have to really examine anything that's to the right of the decimal point, then you're probably wasting your time. … I tend to dismiss the notion that the yield curve inversion in 2019 is telling us with a high degree of confidence that we've begun a recessionary process.”

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