Soft Landing or Recession?

By: Martin Weiss | Mon, Nov 13, 2006
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Money and Markets

Even as the Dow makes all-time highs and investors celebrate with growing enthusiasm, new signs of a slowing U.S. economy have suddenly burst onto the scene:

Housing markets are sinking. Consumer confidence is falling. And GDP growth has plunged.

So everywhere, investors are asking: Is this just a "soft landing" -- a short respite before the next boom? Or is it the prelude to a potentially devastating recession?

Getting this answer wrong could have a damaging impact on virtually every investment and business decision you make in the next twelve months; getting it right can open up major wealth-building opportunities.

So I'm delighted to see that one man has put the hard evidence together in a single, cohesive speech.

He's Claus Vogt, co-editor of Sicheres Geld (the German edition of my Safe Money Report) and co-author of the best selling book, Das Greenspan Dossier.

His speech, just given to subscribers, knocked their socks off. So I've asked him to share the highlights with you right now ...

Soft Landing or Recession?
by Claus Vogt, Co-Editor
Sicheres Geld

I'm a bank economist. So I have a pretty good idea as to how most other bank economists would answer this critical soft-landing-or-recession question.

They'll acknowledge the recent bad news from the U.S. economy, but then say it's just a passing phase.

They'll accept the idea that sales and corporate profits could weaken a bit, but then tell you that's actually "good" for moderating inflation and interest rates.

Plus, they'll give you the impression they're being objective, when their true agenda is to get you to buy the investments they want to sell.

Beware! Before you rush to action, consider the recession warnings now pouring forth from virtually every reliable indicator:

Recession warning #1
A Dramatic Change
In U.S. Interest Rates

You won't see it by looking exclusively at short-term interest rates. Nor will you see it when you look only at long-term rates.

Rather, where you will see the dramatic change is in the all-important difference between short- and long-term rates.

Here are the key facts in a nutshell:

One year ago, long-term rates were significantly higher than short-term rates: The 10-year note was yielding about 4.6%, and the 3-month Treasury-bill rate was near 3.9%.

That was normal, and it made sense: If you're a lender, the longer you have to wait for your money, the more you'll want to charge in interest to cover the risk of future inflation or other troubles.

But today, just 12 months later, we see precisely the opposite pattern: The 10-year note is still yielding 4.6%, while the 3-month Treasury-bill has surpassed 5%. In other words ...

The cost of short-term borrowing is now significantly higher than the cost of long-term borrowing!

This is the so-called "inverted yield curve."

It forces millions of consumers to pay interest rates that are higher than what they can typically afford.

Moreover, it causes falling demand for automobiles, homes, and all those big-ticket items financed by short-term or variable-rate loans.

Recession warning #2
Difference Between Long- and Short-
Term Yields Plunges Below Zero!

The first chart I just showed you depicts two snapshots in time -- a year ago vs. today.

Next, I want to show you how this phenomenon has evolved over the years.

The formula is simple: Just subtract the short-term from the long-term and get the difference.

Applying this formula to my first chart, you'd have:

And applying a very similar formula since the middle of the last century, you get my next chart.

Immediately, it shows you a clear pattern:

As long as the 10-year Treasury-note yield was 2 or 3 percentage points higher than the short-term rates, as it was in recent years, the economy was coasting along nicely.

But now, as the difference between long and short rates has fallen to zero or below, the first phase of the money crunch is here.

Homeowners are feeling the pinch as their variable-rate mortgages, tied to short-term rates, adjust higher. Consumers shopping for autos are feeling the pinch as the once-rampant discount financing deals become much scarcer. And the entire economy is beginning to feel the squeeze.

Moreover, history clearly shows the consequences: In the past half century or more, every time this has happened, the result was: A recession!

And ...

There's no reason to believe it should
be any different this time around!

Some economists might argue that you don't get a recession unless this indicator plunges far below zero.

Yes, back in the mid-70s, and again in the late '70s, it dipped to 400 points below zero.

In other words, money was so scarce, short-term borrowers had to pay four full percentage points more than long-term borrowers.

And yes, that extreme cash crunch caused almost immediate declines in the economy.

But time and again, recessions have also been triggered with far lesser money crunches. My chart shows this clearly -- not only before the last two U.S. recessions but also in recessions as far back as the 1950s.

Conclusion: You don't need a massive decline in this indicator to cause a recession.

Recession warning #3
Manufacturing Index Falls to
Critical Recession Threshold!

The interest-rate crunch is already beginning to impact U.S. manufacturers, especially in the housing and automobile industries, where short-term or variable-rate credit has played such a vital role.

And there are few organizations that track this trend more accurately than the Institute of Supply Management (ISM).

When the ISM's manufacturing index is above 50, it generally signals expansion; below 50, contraction.

Where is it now? It has just fallen to the 50 level, right on the critical threshold of a new recession signal.

Recession warning #4
Housing Market Index Hits Its
Lowest Level Since February 1991!

You've seen the headlines, and you may also see it in your neighborhood: Falling sales of new and used homes, falling demand, and even falling prices.

That's why, just last week, two of the leading home builders reported such dismal results, "confirming that the slump in the once-hot housing market is far from over," according to the New York Times.

Toll Brothers, the largest builder of luxury homes, said its revenues from homebuilding fell 10 percent, its backlog of projects fell 25 percent, and, most shocking of all, its signed contracts plunged 55 percent.

Reason: A rash of contract cancellations, especially in Florida and Northern California.

Beazer Homes is also getting hit hard: Net income plunged 44 percent. New orders plummeted 58 percent.

What's the overall outlook for the industry?

The National Association of Home Builders sums it up by surveying builders about present single-family sales, single-family sales in the next six months and buyer traffic.

Then it compiles the results in a single index: Above 50 means most responses are positive; below 50 means most are negative.

And right now, this index has plunged to its lowest level since February of 1991.

Rarely have we seen a sharper decline! Never have we seen such a decline without consequences -- not only for the housing industry, but for the economy as a whole! And despite a rally in homebuilding stocks Friday, this trend is likely to continue.

Recession warning #5
Housing Market Decline Comes with
Parallel Decline in Consumer Spending!

The close relationship between a housing slump and a consumer slump is undeniable. But this is nothing new, as you can see in the chart below.

The chart takes the same housing market index I showed you a moment ago and compares it with the growth in consumer spending (adjusted for inflation).

Look at the pattern: The last time the housing market index took a stumble -- back in the late 1980s -- it came with a parallel fall in consumer spending.

It makes sense.

And in recent years, with so many U.S. households tapping the equity in their home like an ATM machine, the connection has been even stronger.

But now that cash cow is drying up. So consumer spending is weakening as well.

That's why Wal-Mart's sales have slacked. And that's why other retailers are likely to suffer similarly disappointing results.

The clincher:
Housing Bubble Is by Far
The Biggest of All Time

With all this evidence, it's a bit hard to believe that most economists are still favoring the "soft landing" scenario for the economy.

One of their favorite arguments: The housing market troubles are not big enough to offset the continuing strengths elsewhere.

But the facts cast a long shadow of doubt over that theory: Never before in history has housing played such a large role in the U.S. economy! And never before has the DEBT behind the housing market been as big as today's.

The proof is in my last chart:

Back in the early 1980s, the U.S. had less than 10 cents in mortgage debt outstanding for each dollar of GDP.

Now, that figure has more than doubled to over 22 cents on the dollar.

Similarly (not shown in the chart), mortgage debt has now overshadowed all other forms of debt in the U.S.

The proof: Back in the mid-1970s, the last time the U.S. experienced a major housing-slump driven recession, only about one-fourth of the debts in America were mortgages. Today, over HALF of the debts are mortgages!

These numbers denote massive, sweeping, structural changes. They are telling you not only that the housing boom was a huge speculative bubble, but also that the housing bust promises to be a powerful recessionary force.

The next big question:
How Will the Fed Respond?

Fed Chairman Ben Bernanke has no choice.

If the only threat were a minor, tolerable decline in the economy, he might sit back passively and do little or nothing in response.

But when the economy is sinking into a full-fledged recession ...

When the recession is threatening to cause a growing wave of delinquencies and defaults in the mortgage market, and ...

When the Fed fears those defaults could trigger a domino-like series of bankruptcies in the broader economy ...

Then, Mr. Bernanke will almost inevitably resort to the one tactic that his predecessors and counterparts have used throughout history. He will react with as much economic stimulus as he can muster. He will flood the economy with money. And he will debase the value of the U.S. dollar.

The Big Picture:
Bubbles Are Always
Caused by Easy Money

It's widely recognized that it was the Fed's easy money that was behind the stock market bubble of the 1990s ... and again ... it was the Fed's still-easier money that created the larger housing bubble of the 2000s.

Now, connect the dots: If the Fed was the responsible for the booms, it follows that it's also responsible for the negative consequences of any subsequent busts.

Moreover, it implies that more of the same -- still another round of easy money from the Fed -- is tantamount to treating an alcoholic with alcohol. It will neither prevent the fallout of the bursting bubbles nor cure the economic imbalances they harbor.

My view: The Fed is not part of the solution; it's part of the problem.

And whatever the Fed decides to do will be too little, too late to prevent at least a cyclical recession in the U.S. ... and too much, too soon for any investor who's not prepared for inflation and surging commodity prices.

So be sure to be ready for both: Recession AND inflation.

Best wishes,

Claus Vogt



Martin Weiss

Author: Martin Weiss


Martin Weiss, Ph.D.
Editor, Safe Money Report

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