Another recession? I told you so.

There have been some very severe financial fluctuations in the past 24 hours. I won't even bother linking to any news or financial sites because you know it already. Here in Australia a number of very respected people are saying that this is the beginning of another financial crisis that will inevitably lead to another recession.

At the risk of sounding unbearably smug I have been predicting such an event. To be honest, though, I didn't expect the sudden crunch happening now. Moreover I wasn't basing my prediction upon "gut feeling" but upon data.

It all started back on 2011-06-17 when I wrote a post entitled A Recession indicator has been triggered . This was not just an important predictive event but also an important step in my own understanding. The fact is that for some months now I have been publishing a series of posts called "Recession Indicators". What happened was that my own study of real interest rates seemed to prove conclusively that whenever real 10 year bond rates (10 year bond rates minus inflation) went negative, a recession was inevitable. This is what I said:

What I discovered from this analysis is that while recessions can occur without negative real interest rates, whenever negative real interest rates do occur, they are always followed by an eventual recession. This occurred in 1957, 1974, 1980 and 2008.

So what about the present? Last week US inflation for May 2011 came in at 3.4438% while Ten Year Bond Rates for that month were 3.17%, which meant that real interest rates dropped to -0.2738%... if the June result continues to be negative, and if this continues into July, then the chances are that a recession will be sooner rather than later.

Then on 2011-06-24 I published the June 2011 recession indicators where I said

According to data from negative Real Interest Rates, another US recession is likely to occur between 2012-Q1 to 2014-Q1, with 2012-Q4 being the most likely.

Then on 2011-06-29 I published another post entitled Real Interest Rates are predicting an upcoming recession. Between this post and the previous one I had refined my study of real 10 year bond rates - averaging them out over a 3 month period in order to iron out a statistical "bump" in the data (which turned out to be Hurricane Katrina). By comparing these results to GDP and unemployment data, I came up with the following  assertions:

• Once (real 10 year bond rates) turn negative, a recession occurs, on average, 8½ months later.
• The median is 6 months.
• Results vary between 4 months and 18 months.
• The highest unemployment rate during the recession is, on average, 1.8 times the unemployment rate of the month when real interest rates turn negative.
• The lowest increase is 1.32 times; the highest increase is 2.03 times.

Now the thing about this particular post is that the 3 month average had yet to turn negative, so I prefaced my pronouncement with the caveat that "if" rates went negative the following month, then:

A recession starting between 2011 Q4 and 2012 Q4, with 2012 Q1 (is) most likely.

Then on 2011-06-30 I wrote a lengthy piece about what was likely to occur between now and the recession entitled The events leading up to the coming downturn. The idea was that, because I had two other recession indicators that unerringly predicted past recessions in hindsight, then any potential recession coming up would also have to influence these indicators. I decided that there were going to be two possible situations occurring, an inflationary outcome or a deflationary outcome:

An inflationary outcome would result in inflation outstripping the new monetary base. This would mean that, in the time leading up to the recession, inflation would increase...

The deflationary outcome, like the inflationary one, won't have to be sudden or substantial to presage the recession. If inflation sits at 1% and the Net Monetary Base grows at 0.5% - both near zero but slightly inflationary - the result will still be a negative spread and an upcoming recession. A decrease in the price of oil and an increase in the value of the US Dollar (the USDX) is likely to accompany this deflationary outcome.

The deflationary outcome would mean that the Federal Funds Rate remain low while the 10 Year Bond Rate crashes down to similar levels. This, in turn, would mean that the Bond Rate would be 0.09% or below. This, of course, would indicate massive financial distress that would be accompanied by a sharemarket crash of epic proportions and a credit crunch that would make 2008 look like a picnic.

When I balanced the two out, I decided that the inflationary outcome was more likely. After yesterday's crashing market, there is a much higher likelihood of a deflationary one. To be honest, the thought of the 10 year bond rate dropping below 0.1% is quite frightening.

So they were my June predictions. What about July? On 2011-07-07, when 10 year bond data came out, I wrote an article titled The chance of avoiding another downturn is now almost impossible.

After having my views changed on austerity (namely that the economy was no longer able to produce jobs in a recovery), on 2011-07-09 I outlined "OSO's New Deal" in which I argued that the US Government needs to spend more and tax more in order to a) boost economic growth, and b) generate more revenue to pay off its already considerable debt. While this was not a predictor of events to come, it did outline what I thought (and still think) is the answer to our current economic woes.

On 2011-07-20 I published the next recession indicator series. I made the following points:

If we take previous instances of negative real bond rates into account, a recession will start between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.

Since then my blogging was mainly concerned with the US debt ceiling crisis. Since the resolution of this crisis, the markets have teetered and fallen. While I would no doubt agree that the debt crisis spooked the markets, I would argue, based upon the data and conclusions that I have been publishing since June, that a recession / downturn was always going to happen at some point. It seems like the debt ceiling crisis was the trigger for it happening sooner rather than later.

Now of course I need to add the disclaimer. We're not in another recession just yet - it is still too early to tell whether we are, at present, suffering another downturn. Moreover there is nothing to suggest that the current crisis in financial markets is going to continue like it was 2008. Markets just might do that, but then again they might not. I'm not going to predict how the markets are going to respond over the coming days weeks and months. Nevertheless I do think that there is enough evidence to show that another market downturn and another recession are going to happen within the next 18 months, and I will stick by that.