Without this action, a recession was inevitable. The yield curve was flat for nearly 18 months, from mid 2006 to the end of 2007, usually long enough to stall the economy.
That danger is now past.
Today, the spread between 3 month bills and 10 year notes is fully 250 basis points, a growth signal.
There is still a danger of a continued slowdown in the next few months, but the risk of a protracted recession is past.
This action, when combined with a massive injection of liquidity by the Fed's Open Market Committee to banks and primary dealers, suggests there is little danger of a prolonged recession.
YIELD SPREAD SIGNALS GROWTH
The spread between 3 month Bills and 10 year notes is the best predictor of recession.
Notice the last three recessions were preceded by a flat yield curve.
In Volcker's recession back in the early 80s, the yield curve was negative for an extended periond, signaling an unusually severe contraction.
CURRENT YIELD SPREAD
As the chart below shows, the spread between 3 month bills and10 year notes is about 250 basis points.
This is sufficient to allow for new bank lending and economic growth.
STOCK MARKET CONFIRMATION
The stock market confirms the forecast that the recession is over.
Notice the volume spike back in August of 07. As the effects of a flat yield curve spread throughout the banking and lending communities, the path to recession was clear and the stock market fell below the levels at the volume spike.
The market is now trading above those levels and finding support there.
INFLATION
The problem now is a continued rise in domestic prices both from additional liquidity in the system and from the falling dollar.
TACTICS
Continue to extend the maturity of liabilities to 5 years or longer. Borrowing now will lock in rates for the long term and fuel growth in assets. Be prepared to lock in profitable spreads on new assets.
Money market arbitrage is more profitable than ever. Aggressively raise deposit rates and expand the portfolio. Use the additional funds to acquire high-yield assets knocked down by credit concerns.
STRATEGY
Warn senior management of coming inflation.
Prepare hedging programs to take advantage of any spike in prices to hedge against the future sale of liabilities.
Evaluate credit risks and prepare to take advantage of distressed assets.
Insulate the portfolio from currency risk.
