A US recession and decline in Treasury yields remain likely

The decline to 8.5% in the official unemployment rate in December, from 8.7% the month before, and 200,000 December rise in nonfarm payrolls cap a series of reports that imply the economy is modestly strengthening. But, that strengthening is far more apparent than real and, moreover, is likely to soon be reversed.

This is certainly not a consensus view of the economic outlook. Most economists base their conclusions on where they believe the economy is currently in the typical domestic business cycle. Unfortunately, this is not a typical domestic business cycle. The US economic recovery from the deepest recession since the Depression of the 1930's is still so feeble as to remain near stall speed. And there are new problems ahead, including an end or reversal of some of last year's stimulus and a further wave of foreclosures. Even worse, the US economy is vulnerable to the soon to be developing recession in Europe and the economic slowdown in China and much of the rest of Asia. All this does not even encompass the economic problems that would follow a spike in oil prices if,as threatened, Iran attempts to close the straits of Hormuz, through which much of worlds oil moves.

The December improvement in the employment data was grossly exaggerated by special factors. The December decline in unemployment rate was parly due to an abberational 50,000 drop in the labor force as discouraged workers gave up looking for work. The 200,000 increase in nonfarm payrolls was boosted by some 42,000 increase in delivery jobs undoubtedly connected to holiday sales, especially from the internet, and the warmer than normal weather that lifted seasonally-adjusted construction jobs by 17,000. Both these sources of December employment strength are likely to be reversed in coming months. As a consequence of these and other economic negatives, the unemployment rate will rise again, while nonfarm payroll gains will slow.

While the major risk of a US recession that I percieve is not a consensus view, I am not alone in what may seem my pessimism, or more appropriately, my realism. The Federal Reserve Bank of San Francisco's forecasting model places the probability of renewed recession this year at more than 50%. I agree. While a US return to recession is not certain, it appears likely. Similarly, even after Friday's employment report, Pimco's El Erain still puts the probability of recession at 30% to 40%.

The European sovereign debt crisis has not been resolved, despite the efforts of the European Central Bank to provide sizable liquidity to the most troubled European Government credit markets. A default by Greece remains likely as early as March. That could create a contagion effect for other weak European Government credit markets including Italy, Portugal and Spain. There is also a continuing risk of a downgrading of the credit rating of France and other beleagured European countries. That also implies contagion risk. Italy's borrowing costs have spiked, depressing the Euro to 16-month lows. Expect these problems to not only persist but to worsen, producing proliferating European economic austerity.

The Treasury 30-year bond yield, which has moved just above 3.0%, is likely to decline toward 2.0%. The Treasury 10-year yield, currently 1.96%, is likely to decline to between 1.25% and 1.5%. As you will note, the forecast implies a further decline in the 10-year to 30-year maturity yield spread from the current more than 100 basis points (more than 1.0 full percentage point)toward 50 basis points. That will also further drive down the yields, and drive up the prices, of high-grade corporates and municipal bonds. That would also be consistent with a decline in inflation fears, general commodity prices (though not gold prices) and inevitably equity prices.

Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, New York 11731

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I can be reached at philipbraverman@gmail.com