5 Reasons Why We Are Closer to a Recession

Here's a truism – just because many people don't want something to happen doesn't mean it won't. An example: Recessions happen even though people don't want them to. Most people don't even want to think about an economic recession. For instance, here's the lead from a recent story in the Financial Times, "The R-word Surfaces on Wall Street":

"The R-word is usually avoided by Wall Street's economists. It tends to be a conversation-stopper when investment bank clients are told to prepare for the worst. 'It is like looking a client in the eye and telling them that their child is ugly,' says David Rosenberg, chief economist at Merrill Lynch. It is not what people want to hear" (Financial Times, Sept. 10, 2007).

But recent follies in the credit and debt markets point to a strong possibility of an economic slowdown in the U.S. Here are five reasons why I think we are closer to a recession than we were two months ago before the subprime mortgage market imploded.

1. Inverted yield curve

No one can explain why -- not even economists who have studied the relationship -- but when long-term interest rates have lower yields than short-term interest rates (inverting the normal yield curve), a recession tends to follow. Economists from the New York and San Francisco Federal Reserve Banks have studied the phenomenon, and they seem to agree that an inverted yield curve can be a leading indictor for a recession.

Guess what? The yield curve has been inverted for more than six months, clearly a bearish signal for the markets. And although it's now "racing back to normal," as financial forecaster Bob Prechter of Elliott Wave International puts it, because short rates are "falling back below long rates, we know that the demand for short-term loans is down, indicating a cooling economy (Elliott Wave Theorist, Aug. 26, 2007). In other words, Prechter sees the movements of the interest-rate spread in and out of the inverted yield curve as a one-two punch that should lead to a recession.

2. Falling house prices

We are in the worst housing slump in 16 years. The housing market started falling apart two years ago, after unprecedented growth led home buyers to believe that they simply couldn't go wrong buying a house – or two or three. As long as prices kept going up, they had a winning hand. But now house prices have begun to fall off their highs, and there's no telling how long this housing contraction could last.

A report out this week shows that home prices in the 20 U.S. metropolitan areas in the S&P/Case-Shiller index fell 3.9 perecent over 12 months through July. That decline followed a 3.4 percent decrease in June for the previous 12 months.

Various economists predict that the U.S. housing market, which is worth about $20 trillion, could fall between 10 percent and 25 percent. Based on a 20 percent decline – a loss of $4 trillion – financial forecaster John Mauldin sees this unhappy consequence:

"Even though housing is only 5 percent of the economy, it is a huge part of the Wealth Effect. Four trillion is not a small sum in the psychology of the consumer. Slower consumer spending, and consumer spending is clearly slowing, is the transmission which takes us from a housing recession to a general recession" (Thoughts from the Front Line, Sept. 21, 2007).

3. Credit crunch and uncertainty in debt markets

It's one thing not to have a lot of cash on hand, and it's even worse not to be able to get credit to keep on buying. Although, banks have been loath to loan money lately for mortgages since subprime mortgages have gone belly up.

Foreclosures on houses backed by subprime mortgages are approaching 14 percent, much higher than the 1 percent or so for prime mortgages. In addition, securities that include subprime mortgages are widely owned by banks, and judging from the higher-than-normal London Interbank Offered Rates (LIBOR) they now charge to borrow funds from one another, there's mistrust and uncertainty as to who has losses and how high they can go.

In turn, financial institutions stop lending as much and tighten their standards. This behavior has resulted in a classic credit crunch. Uncertainty, fear and lack of credit are necessary ingredients of recessions.

4. Defaults to hit corporate balance sheets

So, it's one thing for mortgagees to default on their debt and be foreclosed upon. But now Standard & Poor's is warning that corporate America is about to feel the same kind of pain. According to an article in the Financial Times, the credit-rating agency said that the "slowing economy and ongoing liquidity squeeze put some 75 junk-rated companies, mostly in the media, healthcare and consumer products sectors, at a high risk of default over the next 15 months." Possible amount of debt these companies might default on? About $35 billion, which doesn't yet rival the $250 billion-worth of corporate bonds that defaulted during the debt crisis in 2001-2. But then this figure could balloon, since S&P did not include homebuilders.

5. Falling dollar

People who don't normally pay that much attention to financial markets got a wake-up call last week. Take my husband who was shocked to read that the Canadian dollar is now worth more than the U.S. dollar. Besides the obvious concern about paying more to buy Canadian beer, he jokes that we might soon all be adding the phrase, "eh?," to the ends of our sentences. With other currencies like the euro strengthening against the U.S. dollar, it's true that we will sell more of our own cheaper goods, such as tractors and computers. But it's also true that we will pay more for U.S. dollar-denominated imported goods and oil. That means less money to spend on other goods, which will affect many businesses' bottom lines. And there's a deeper reason for concern about a weak currency: Countries that have been buying our debt, such as China and Japan, won't want to hold a currency that is losing value. Nor will they want to buy more of our debt, unless we offer them higher rates of return, which leads to lower economic growth here in the United States.

Can you say re-ces-sion, eh?

Susan C. Walker writes for Elliott Wave International, a market forecasting and technical analysis company. She has been an associate editor with Inc. magazine, a newspaper writer and editor, an investor relations executive and a speechwriter for the Federal Reserve Bank of Atlanta. She is a graduate of Stanford University.