Published: November 9, 2009

A new report contains some very good news for investors: Double-dip recessions are very rare.

That means that a drop back into recessionary conditions looks less and less likely even as unemployment creeps higher and has crossed the 10% threshold for the first time in a quarter century.

After reviewing U.S. economic history all the way back to the 1850s, Deutsche Bank AG economists found that double-dip recessions are exceedingly rare: There have only been three episodes in which the economy has fallen back into recession within a year of a previous recession ending. And that’s out of 33 recessions that have taken place since 1854.

Indeed, when these double-dip downturns do occur, they happen under circumstances quite different from today’s situation.

Two of the three double-dips happened in the years prior to World War II -- in 1913, and again in 1920. The more relevant example was the double-dip recession of the early 1980s, which was driven by the fight against double-digit inflation rates.

U.S. President Jimmy Carter imposed credit controls in March 1980, which resulted in a sharp but short-lived recession before the economy expanded again for 12 months. Then U.S. Federal Reserve Chairman Paul A. Volker hiked short-term interest rates to 20% in the summer of 1981, as he pushed the economy back into recession but dealt a death blow to inflation.

With deflation just as likely as inflation at the moment, a repeat of the 1980s just isn’t in the cards, as the Fed is set to keep rates at very low levels until the end of 2010.

Tom McClellan of the McClellan Market Report has some more potentially good news. As you can see in the chart above, the level of employment tends to follow stocks on a 12-month lag. It’s not a perfect match: The red numbers show the actual lags of important turning points over the last forty years. But the correlation is strong enough to provide one more piece of evidence that the “turn” in employment is perhaps four months or so in the future.

So while the public will continue to be preoccupied by a still rising unemployment rate and political chatter over the perceived failure of the Obama administration’s stimulus package -- the market will continue to anticipate the improvement just over the horizon.

One final note: The economists at ISI Group note that outside of the United States, employment already started to grow in 11 economies. These include Japan, Canada, Singapore, Brazil, Russia, Sweden, and Taiwan. Stocks have sniffed out the fact that a global employment turn is already happening. The U.S. economy just isn’t fully participating yet, but it will.

Financial television was all atwitter last week during the Fed’s policymaking Federal Open Market Committee (FOMC) meeting, wondering if central bank governors would raise rates. They shouldn’t have wasted their breath. The Fed is very unlikely to raise rates next year -- and if it does, it won’t be until the 2010 fourth quarter.

History shows the Federal Reserve has never increased interest rates while unemployment was still rising. In fact, the Fed has waited at least six months after the peak in unemployment and when the unemployment rate has dropped by 0.7% from its high before hiking rates according to the Deutsche Bank report. Moreover, during periods of low to no inflation -- like we have now -- the Fed can wait twice as long before raising rates.
 

Given their forecast for unemployment -- peaking this quarter before falling back to 9% in the latter part of 2010 -- Deutsche Bank economists expect the first tightening of 0.25% to occur at the Fed’s August 2010 meeting. They see another 0.25% hike the ensuing September meeting to be followed by a 0.5% hike at the November meeting. After that, the team expects 0.5% hikes during alternating meetings. This would bring short-term interest rates to 1.25% next year and 3.25% in 2011.

Yet an ultra-low interest rate is not the only policy tool the Fed is using. Various rescue programs, along with unconventional “quantitative easing” strategies that saw the Fed make direct purchases of U.S. Treasury Department debt and mortgage securities, has more than doubled the Fed’s balance sheet to more than $2 trillion. Some believe that the Fed will start to sell off its assets, thereby pushing up long-term interest rates, before it raises its short-term policy rate. This would raise both mortgage rates as well as the government’s cost of borrowing.

Given the worries over the federal deficit as well as the fragile state of the housing market, I don’t think this is likely. Instead, I expect the Fed will increase the interest rate it pays to banks that park extra cash in its vaults instead of lending it out. This helps suck extra dollars out of the system while not disrupting the bond market with an influx of supply.

Starting late next year, look for the Fed to possibly raise its policy rate as well as the interest rate it pays to banks. Mortgage rates and other long-term interest rates should start creeping higher next spring as the Federal Reserve ends its direct purchase program. But a large spike in rates will likely be avoided as the Fed slowly sells the debt it’s already purchased. The Fed will try to avoid being seen as the heavy for any dislocation that might follow at all costs.

Stocks are poised to recover and to pounce toward new highs. They are oversold, the Fed is holding the line, and earnings growth is on track. The past week’s performance was anemic, but bulls still have control of the wheel.

How to play this: Just to keep it simple, hold Vanguard Total World Stock Market Exchange Traded Fund (NYSE: VTI) to participate.

The ETF trades around $42. The target price is $45. Set a sell stop in case of trouble.

-- Jon D. Markman
Contributing Writer
Money Morning