USA: greater risk of recession than earlier thought?

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Greenspan Is Wrong: Yields Say Recession Risk Is 50 Percent

By Daniel Kruger

 

March 12 (Bloomberg) -- Alan Greenspan, who jolted investors by

predicting a one-in-three chance of a recession this year, isn't as

bearish as the bond market, where the risk of a downturn is even money.

 

The probability the U.S. economy will shrink for two quarters has

risen to 50 percent, according to a model created when Greenspan ran

the Board of Governors of the Federal Reserve System. The formula is

based on differences in yields on Treasuries.

 

The economy has gone into recession six of the seven times since 1960

that short-term interest rates topped longer-term bond yields, as they

do now. The difference between three-month bills and benchmark 10-year

notes is close to the widest since 2001. Investors say the so-called

inverted yield curve is a sign the Fed will cut borrowing costs

because the economy is decelerating.

 

``We're going to have slower growth,'' said Barr Segal, a managing

director at TCW Group Inc., a Los Angeles-based firm that oversees $80

billion in fixed-income assets. ``The fundamentals of the economy are

what you have to watch.''

 

Investors have used interest rates to predict the economy since 1913,

according to a Fed study. Short-term rates have exceeded long-term

yields since July, in part because of demand for Treasuries from China

and other central banks. The yield difference may now be sending a

message about the economy, some investors say.

 

``The yield curve should not be ignored,'' said Saumil Parikh, who

helps manage $688 billion at Pacific Investment Management Co., in

Newport Beach, California. ``The fact that the yield curve is inverted

gives us a signal that overnight rates are too high. That's what the

yield curve is telling the Fed.''

 

Better Predictor

 

Treasuries fell last week as the government said the U.S. added more

jobs than forecast and stock markets rebounded. The yield on the 4 5/8

percent note maturing in February 2017 rose 9 basis points to 4.59

percent.

 

A yield-curve model the Fed developed in 2006 is based on research by

staff economist Jonathan Wright, as well as analysis from the 1990s by

two economists at the Federal Reserve Bank of New York, Arturo

Estrella and Frederic Mishkin. Christopher Low, chief economist in New

York at FTN Financial, used the model to determine that the

50-basis-point yield gap between three-month bills and 10-year

Treasuries would amount to a 50 percent likelihood of a recession over

the next year.

 

Estrella and Mishkin's study said Treasury yields are a better

predictor of recessions than stock prices. That's because relatively

high short-term rates slow the economy while lower longer-term rates

reflect the outlook for weaker growth and inflation, they wrote.

 

`Imbalances Can Emerge'

 

Treasury yields may be less of a predictor this time because of demand

for U.S. securities from foreign investors, said David Ader, head of

government bond strategy in Greenwich, Connecticut, at RBS Greenwich

Capital, one of the 21 primary dealers that trade directly with the Fed.

 

Overseas investors bought $198.6 billion more Treasury notes and bonds

than they sold in 2006, up from $18.5 billion in 2001, according to

the Treasury Department.

 

``We are in the sixth year of a recovery; imbalances can emerge as a

result,'' the 81-year-old Greenspan said in a March 5 interview with

Bloomberg. ``Ten-year recoveries have been part of a much broader

global phenomenon. The historically normal business cycle is much

shorter'' and is likely to be this time, he added.

 

Mishkin, a Columbia University economist, was sworn in as a Fed

governor in September. Mishkin and Wright declined to comment.

Estrella, a senior vice president in the Research and Statistics Group

of the New York Fed, also declined to comment. Greenspan declined to

comment.

 

`Policy Is Biting'

 

Three-month bills have exceeded the yield on notes since July 19,

three weeks after the central bank raised its overnight lending rate

between banks to 5.25 percent, the last of 17 straight increases since

2004. The gap widened to as much as 60 basis points on Feb. 27, the

widest since February 2001. A basis point is 0.01 percentage point.

 

``It's an indication monetary policy is biting,'' said Lacy Hunt,

chief economist at Hoisington Investment Management Co. in Austin,

Texas, which manages $4.8 billion of Treasuries. ``You have fairly

severe monetary restraint on the system.''

 

The Fed's decision to raise rates preceded recessions and contributed

to corporate failures including Penn Central Railroad in 1970,

Franklin National Bank in 1974, and Continental Illinois National Bank

& Trust Co. in 1984, said Hunt, a former senior economist at the

Federal Reserve Bank of Dallas.

 

`Being Cautious'

 

Greenspan, speaking on a videoconference call to investors in Hong

Kong Feb. 26, said slowing growth in profit margins was a sign the

expansion might be winding down, according to the Associated Press.

Treasuries rose the most since December 2004 and stocks fell the most

since 2002 the next day.

 

Greenspan was ``being cautious,'' said Low of FTN, who expects the

economy to grow 1.5 percent to 2 percent in 2007. ``He was saying in a

roundabout way that Fed policy is tight.''

 

On Feb. 28, Fed Chairman Ben S. Bernanke said the central bank expects

the economy to pick up. There's little indication that subprime

mortgage defaults have spread, Bernanke told the House Budget Committee.

 

The Fed says the economy to grow 2.5 percent to 3 percent this year

and 2.75 percent to 3 percent next year, according to forecasts

presented to Congress last month.

 

``The economy's growth pace is moderating and will probably grow below

potential,'' said Tony Rodriguez, who oversees $70 billion as head of

fixed income at FAF Advisors in Minneapolis, the asset-management arm

of U.S. Bancorp. Treasury yields are ``pointing toward an economy

that's moderating.''

 

To contact the reporter on this story: Daniel Kruger in New York at

dkruger1

Last Updated: March 11, 2007 11:02 EDT