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.

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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, Intrade.com, 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.

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And with a meeting of the Fed’s Open Market Committee (FOMC) around the corner, what does Intrade.com 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:

≥4.0%:

97%
≥4.25%: 95%
≥4.5%: 77.5%
≥4.75%: 45%
≥5.0%: 25%
≥5.25%: 6%
   

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 Intrade.com 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.

30-DAY FED FUNDS FUTURES*

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* The implied interest rate is obtained by subtracting the price of the October Fed funds futures contract from 100
Source: http://www.cbot.com


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