US economy – R or no R?

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One of the most perplexing and widely-debated financial issues is whether the US economy will experience the dreaded R (= recession) in the current cycle.

Highly-regarded Asha Bangalore of Northern Trust argues that the sharp downturn in US private residential investment is pointing to a downswing in US GDP growth. She motivates this in terms of the chart below, depicting inflation-adjusted residential investment expenditures and GDP growth from 1954 onwards. “The main conclusion from here is that sharp declines in residential investment expenditures are associated with recessions with the exception of two periods – 1966 to 67 and 1995. During both these periods, the Fed eased monetary policy and stimulated economic growth,” said Bangalore.


Source: Northern Trust

“ … the declines in residential investment expenditures come in different sizes but when they occur they are almost always associated with a downswing in real GDP growth. Without doubt there are several factors accounting for any given recession. As a reminder, the weakness in residential investment expenditures began long before the current financial market turmoil,” remarked Bangalore.

Slower GDP growth is one thing, but what about a proper recession (i.e. two consecutive quarters of negative growth)? Finding a credible answer to this question is not easy. I still recall how the 50 economists making up the Blue Chip panel were unanimous in 2001 about the US economy not going into recession. Alas, when the forecast was made the dreaded recession was already upon us.

But why wonder about the odds when there is a futures market,, from which one can glean some guidance. Trading volumes are low, but contract prices nevertheless give an indication. According to the last trades, the chances of the US economy hitting a recession in 2007 are 9.5%, but this figure rises dramatically to 58% when it comes to 2008.

The chart below shows the price history of the 2008 contract, and specifically how the odds have almost doubled since the Fed’s discount rate cut on August 17.


And with a meeting of the Fed’s Open Market Committee (FOMC) around the corner, what does say about the outlook for the fed funds rate? It offers a series of contracts betting that the fed funds rate will be on or above certain levels by December 31, 2007. The latest trades are:



I am in the somewhat pessimistic camp and concur with about a 60% chance of the big R making its appearance in 2008 – that at least is what my gut tells me. After all, if I had a different figure, I should put my money where my mouth is and hit the bids or offers of the doubles.

As far as interest rates cuts are concerned, I will go along with -25 basis points on September 18, but that will only be the first bullet being fired from a magazine filled to capacity by Alan G.

For the sake of completeness, let’s also look at the 30-day federal funds futures contract (expiring in October 2007). Although not a perfect indicator, it seems to imply a fed funds rate of 4.85% and is therefore currently pricing in a 100% probability that the FOMC will decrease the target rate by at least 25 basis points at Tuesday’s meeting.


* The implied interest rate is obtained by subtracting the price of the October Fed funds futures contract from 100

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3 comments to US economy – R or no R?

  • stevo

    Whether the US slips into a recession, or not, depends upon a multiplicity of factors. The first is the actions of the FED. Do the ruling bankers wish to clean the accumulated, sticky cobwebs from the economy, or do they want to keep the present game afloat by inflating some other bubbles? The second is consumer behavior. Consumer spending accounts for 70% of US GDP. Do these big spenders want to continue living their historical, unsustainable lifestyles, in the light of declining real incomes, at the eventual cost of pauperism? The third is fallout from the presidential election cycle. To-be president Hillary is a dyed-in-the-wool socialist under whose administration capital formation and capital security will be debased. She has already called for a tax on the “rich” to help fund her expansive health care program.

    A simple forecasting tool the Fed used to employ to project economic growth one year in advance is 1.8+[0.97(30 year bond yield-3 month bill yield)]. With current rates of 4.73% and 4.16%, respectively, projected GDP growth over the next year should approximate +2.4%. Since present GDP growth is +1.9% [11523.8/11306.7*100)-100](2nd quarter numbers), the Fed model seems to forecast an economic “pick-up”. Also, another useful forecasting tool, the yield spread, is positive, suggesting an expanding economy in prospect. Trying to model what is really happening in a dynamic economy with a few mathematical formulae is usually an endevor in futility and richly deserves the derision now being heaped upon it.

    However, the year-over-year ratio of the SP500 to Nominal GDP indicates that the stock market is entering dangerous territory from which significant declines often occur. Since 1950, all recessions (with the exception of the one in 1980) have been preceded by a declining stock market. I believe stocks will decline sharply in 2008 (after reaching one last, new high in 2007) in anticipation of: 1) a dollar crash which will reduce the American middle class to serf status; 2) President Hillary reforming the USA into the USSA (United Socialist States of America); 3) the widening disparity of incomes between haves and have-nots will accelerate into serious social strains; 4) racial tensions will fester between Hispanics and everyone else; 5) the North Anerican Union will be stillborn; 6) capital controls will be instituted to abate the exit of hot money; and 7) the price of that barbarous relic, gold (and its weak sister, silver), will top-out somewhere beyond the orbit of Saturn.

  • stevo


    As an econometrician, my studies are driven by economic relationships. The latest balance between interest rates has revised my price targets, as follows:

    SP500 — Target #1 1816; Target #2 2006.
    US Dollar index — Target #1 76.00 (Still OK); Target #2 62.86 (Very bad); Target #3 51.53 (Disaster).
    Gold — 970.2 (I am no longer doubtful about this metal’s prospects in the short term).
    Oil — 89.07 (Hello, US recession!).

    And now a lemming test:

    by Ringling Whett

    The lemmings circled ‘round the ancient rock
    In hopes they’d get the mystic glyphs to talk.
    But the senseless stone could not hear their cry,
    And would not tell them to buy low, sell high.

    One of this breed had an appealing squeal
    That made the others want to do a deal.
    They bought with vigor till their stash was dry…
    To watch that thing flame-out across the sky.

    Whatever was reported in the news
    Could give the lemmings excitement, or blues.
    Instead of drinking deeply from this fount,
    They should have recalled that markets discount.

    A certain lemming broke free from the pack,
    But soon the others were close on his track.
    They all were victims of a woeful end,
    Because they overlooked the major trend.

    One should have feelings somewhat less than proud
    If he’s a member of a massive crowd.
    And ‘though the many hear the Sirens’ call,
    The group surviving will be very small.

    To plunge in markets is a tough pursuit —
    You must subject emotions to dispute —
    And if the water seems right for swimming,
    Consider that you might be a lemming!

  • Friday, September 21st 2007

    Double Top – the Maximum upside!

    What most players don’t realize is that the upside of this Spike is limited by the previous high. Click on the blue hyperlink above to view an updated chart of the Dow, illustrating the point. The beginning of this drop, labeled Max upside, can be equaled, but not exceeded until the collapse runs its course…. when Friday’s euphoria wears off by Monday, selling pressure begins to build. In crude terms, this formation is a “Double Top”. What’s more, after a Spike such as this, an equal or greater force down, kicks off the collapse. It’s like an object hurled up into the air, once it reaches the zenith, it begins to accelerate back down. Once a Spike from a Diagonal Triangle peaks, it swiftly retraces back to least the point of origin which is 12,520 for the Dow. We’ve had Diagonal Triangles foretelling this decline as far back as 2005.

    Subscribers of the Exceptional Bear Market Letter were long going into the Spike and reversed today shortly before the close. After reading this you will be able to distinguish a good market timer from a lucky one. If anyone who tells you, that the Dow is headed above 14,000, or forecasts the S&P 500 climbing above 1560, before a 30% minimum decline, chances are he’s been lucky, rather than smart. The Bear Market won’t be so kind. Go ahead and ask for their prognostications …but do it soon, before the evening news gets wind of the imminent collapse.

    It’s too late to get in on the Bull Market − it’s over. Going forward, if you intend to prosper, it is crucial that you adjust your game plan. This Bear Market can be expected to last for the rest of our lives. Follow the link to the Exceptional Bear website, where you’ll learn why Bull Market “success strategies” now become your Achilles heel, as the rules of investing are virtually turned up-side-down. Like the market, the fortunes of Warren Buffets & company are headed for a dramatic reversal. We are still offering to double your money back if you fail to make 30% over the next six months employing our asset allocation strategy.

    Eduardo Mirahyes

    Exceptional Bear Market Letter

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