What kills a bull market?

The current bull market is the longest in history, but bull markets don't die of old age. So what could end this record run? Christine Romans breaks down the possible culprits.

Posted: Oct 20, 2018 3:50 PM
Updated: Oct 20, 2018 4:08 PM

The unemployment rate is a record low 3.7%. Wages are going up at a faster pace. Inflation has picked up. The Federal Reserve is tapping the breaks, and long-term interest rates are rising. The economy is red hot.

So it's time we talk about the next recession.

I believe that the next recession is coming into view — the summer of 2020, to be precise.

The best long-leading indicator of an oncoming recession is when the economy passes through full employment. Economists endlessly debate the definition of full employment, but most think a good benchmark is a 4.5% unemployment rate. This is the so-called full-employment unemployment rate or natural rate of unemployment.

When the actual unemployment rate falls below the natural rate, wage growth accelerates, squeezing businesses' profits and causing them to raise prices for their wares more quickly. The higher inflation prompts the Federal Reserve to tighten monetary policy, and long-term interest rates to rise. The economy eventually overheats.

The Fed hopes that it can tighten policy just enough to cool off the economy — by causing unemployment to rise back to its natural rate — before it overheats. A common metaphor is that the Fed is trying to pilot the economy to a soft landing. This is very tricky to do, and in fact the Fed rarely succeeds.

The problem is that once unemployment starts to rise, even from a very low level, a vicious cycle quickly develops. The increase in unemployment worries consumers who turn a bit more cautious in their spending. Businesses see that and hire fewer people. Unemployment rises some more. Consumers and businesses pull back more. The economy invariably crashes.

Soft-landing the economic plane gets harder the farther unemployment falls below the natural rate. That's because unemployment has to rise more to get back to the natural rate before it overheats. It's like the Fed is trying to land the economic plane when it is approaching the tarmac at 250 miles an hour.

Given the massive fiscal stimulus that's temporarily juicing up the economy — deficit-financed tax cuts and increases in federal government spending — the unemployment rate appears headed to near 3% by the end of the decade. If so, the Fed will need to pilot the economy from a 3% to a 4.5% unemployment rate without crashing the economy. Hmmm.

If history is a guide, it takes approximately three years after the economy passes through full employment for a recession to ensue. Unemployment fell below the 4.5% natural rate in summer 2017, meaning the next recession will be in summer 2020.

Another very prescient leading indicator of recession is the Treasury yield curve, and it suggests the same thing. Typically, the curve is upward sloping, with yields on long-term bonds higher than on short-term securities. But leading up to recessions, the yield curve typically inverts, with short rates surging past long-term yields.

Inversions happen in the later stages of a business cycle when the Fed is pushing up short-term rates to head off developing inflationary pressures. Bond investors anticipate that the Fed's actions will ultimately slow economic growth and inflation, and thus investors purchase more bonds. Long-term yields stabilize or even fall. Invariably the Fed pushes too hard and a recession ensues.

An inverted yield curve also makes it difficult for banks to earn an acceptable return on their lending. Financial institutions generally make money by borrowing short and lending long, as they say. This business model works well when the curve is positively sloped, but doesn't when the curve inverts. Creditors are forced to rein in their lending, which exposes past lending mistakes and weighs on economic growth.

Most prophetic is the difference between the yield on 10-year Treasury bonds and three-month Treasury bills. With 10-year Treasury yields now just over 3%, quickly rising three-month bill rates are within three-quarters of a percentage point, which in times past has accurately signaled a coming problem. And although the yield curve is still a ways away from inverting, given expectations for the Fed to steadily tighten policy as unemployment falls, a fully inverted curve seems plausible as soon as next summer.

It's trendy these days to argue that the yield curve has lost its power to predict recessions. Count me on the defense team. The yield curve remains as good a way to predict turning points in the economy as it has been. This time isn't different, as some argue. Historically, an inverted curve occurs, on average, approximately one year before a recession. If our script for the yield curve plays out, then part of it would be a recession in summer 2020.

Buckle in.

Mississippi Coronavirus Cases

Data is updated nightly.

Cases: 515504

Reported Deaths: 10296
CountyCasesDeaths
Harrison34999558
DeSoto33360432
Hinds32743643
Jackson24906392
Rankin22565405
Lee16455245
Madison14954283
Jones14158248
Forrest13834260
Lauderdale12311323
Lowndes11357193
Lamar10693140
Pearl River9748244
Lafayette8868143
Hancock7849132
Washington7559169
Oktibbeha7229138
Monroe7068179
Pontotoc7033110
Warren6885178
Panola6791135
Neshoba6744210
Marshall6707142
Bolivar6468151
Union643598
Pike5942157
Alcorn5921107
Lincoln5540136
George510680
Prentiss508285
Tippah495683
Itawamba4884107
Scott478999
Tate4777117
Adams4776125
Leflore4749144
Copiah458195
Yazoo458092
Simpson4566117
Wayne443472
Covington434895
Sunflower4319106
Marion4295112
Coahoma4244110
Leake414191
Newton396182
Tishomingo386894
Grenada3789109
Stone366166
Jasper341266
Attala340490
Chickasaw318367
Winston318392
Clay312978
Clarke301695
Calhoun286850
Holmes272889
Smith270552
Yalobusha244947
Tallahatchie232353
Greene225149
Walthall222166
Lawrence220242
Perry214556
Amite210357
Webster206548
Noxubee188843
Montgomery182157
Carroll175441
Jefferson Davis174343
Tunica163539
Benton153139
Kemper145441
Choctaw137027
Claiborne134839
Humphreys132239
Franklin126530
Quitman107828
Wilkinson106139
Jefferson97134
Sharkey65321
Issaquena1957
Unassigned00

Alabama Coronavirus Cases

Cases: 847659

Reported Deaths: 16172
CountyCasesDeaths
Jefferson1163752005
Mobile743371381
Madison53434738
Shelby38413371
Baldwin38171589
Tuscaloosa36131643
Montgomery34571782
Lee25664264
Calhoun22622519
Morgan22527408
Etowah20059520
Marshall18821318
Houston17769426
St. Clair16946359
Limestone16192220
Cullman16140305
Elmore15948295
Lauderdale15055307
Talladega14244302
DeKalb13061271
Walker12138380
Blount10765193
Autauga10545157
Jackson10204195
Coffee9435192
Colbert9363210
Dale9038192
Tallapoosa7283202
Russell710165
Chilton7078170
Covington6967197
Escambia6962144
Franklin6364108
Chambers5795142
Marion5435130
Dallas5302210
Pike5128109
Clarke485686
Lawrence4845130
Winston4785110
Geneva4650136
Bibb435495
Barbour370180
Butler3444101
Marengo342793
Monroe338366
Randolph337767
Pickens334790
Fayette331485
Henry321066
Cherokee319964
Hale318889
Crenshaw261678
Washington256852
Cleburne255460
Lamar253555
Clay252069
Macon245767
Conecuh193562
Coosa185847
Wilcox178338
Lowndes178268
Bullock152745
Perry141840
Sumter139741
Greene130345
Choctaw94328
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