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Why a double-dip recession is extremely unlikely

It seems like every day I read about some economist or pundit predicting another recession, an economic slump, or another market crash. This undoubtedly sends chills up the spine of most investors, especially those who are "once burned, twice shy." The past year and a half have been so traumatic that it's only natural to worry that the future holds more nasty surprises. And for those who worry, there is no shortage of bad news. We've known for months that the unemployment rate is extremely high, that the housing market is facing another wave of foreclosure sales, that hotel occupancy rates are dismally low, that layoffs are continuing, that oil prices are rising again, that deflation threatens, that construction spending is very weak, that California is on the verge of bankruptcy, that the federal deficit is gargantuan, etc.

Fortunately, there is some very good news out there that doesn't get much air time. These two charts contain extremely valuable information about the future of the economy that is supplied in real-time, courtesy of the highly liquid U.S. bond market.

The top chart is the spread between the yield on 2- and 10-year Treasury bonds. When the spread is high, the yield curve is very steep, and a steep yield curve is a classic sign of easy money. When the spread is low or negative, the yield curve is flat or inverted, and that is a classic sign of very tight money. All of the post-war recessions in the U.S. have been preceded by one or more years of very tight monetary policy, and an inverted yield curve. All of the post-war recoveries from recessions have been accompanied by easy money, and a steep yield curve. Since the curve is steeper now than it has ever been, we can assume that monetary policy has never been so accommodative, and the likelihood of recovery has never been so high.

The second chart plots the spread on 5-year swaps. (See here for a basic primer on swap spreads.) This spread tells us a lot about how liquid the market is (low spreads = high liquidity), how risk-averse the market is (low spreads = low risk aversion), and what the generic risk of AA credit defaults is (low spreads = low default risk). Swap spreads have had an uncanny ability to foresee the economic health of the economy. They tend to rise well in advance of recessions, and they tend to decline well in advance of recoveries. (I first began forecasting an end to the recession in late 2008 because of the huge drop in swap spreads.) With swap spreads today trading at very low levels, the market is telling us that credit risk is very low, economic stress is very low, risk-aversion is very low, and default risk is very low. You couldn't ask for anything better.

Taken together, these two charts send a powerful and very reassuring message: the economic fundamentals have improved dramatically, and augur strongly for recovery.

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