The Odds On A U.S. Recession

The yield curve says they're rising

With some 40% of the world economy already contracting, fears are growing that the U.S. itself will be dragged into recession. While most economists believe it can avoid this fate--particularly with the Federal Reserve's shift toward monetary ease--most also admit that the risks of recession have risen in recent months.

One way of assessing those risks is to relate them to the shape of the yield curve--the spread between interest rates on debt securities with different maturities. Among the most sensitive of leading economic indicators, the yield curve is normally upward-sloping, with short-term rates lower than long-term rates. An upwardly sloping curve points to expanding economic activity ahead.

When the curve flattens or inverts, on the other hand, it almost invariably signals a coming slowdown or contraction. As it happens, the slope of the curve has been dropping sharply over the past year and has recently been almost flat. Even after the Fed's recent quarter-point rate cut, virtually the entire spectrum of interest rates is now below the rate on overnight money set by the Fed.

In 1996, a study by economists at the Federal Reserve Bank of New York found that the yield curve was a far better predictor of coming recessions than a number of other leading economic variables, including stock prices and the index of leading indicators. Using data from 1960 to 1995, the researchers constructed an index of the probability of a recession occurring four quarters ahead, based on how much interest rates on 10-year Treasuries exceed or fall below those on 3-month Treasury bills.

Back in early August, this spread was positive by about 0.45 of a percentage point, indicating that the chance of a recession in a year's time was only 15% or so, according to the New York Fed study. But since then the spread has almost disappeared (chart), raising the risk of a recession in 1999 to 25%. (For the risk to exceed 50%, 10-year rates would have to fall below 3-month rates by 0.83 of a percentage point.)

While a 25% recession risk may appear small, it's noteworthy that the spread gave off exactly the same signal in late 1989, a year before the 1990 recession. Moreover, the researchers point out that the yield curve has been a lot less variable in the 1990s than in earlier decades, lessening the likelihood of strong recessionary signals.

Many economists see the odds of a downturn next year as even greater. Salomon Smith Barney puts the risk at 35%. James Glassman of Chase Securities Inc. places it at 50%. And Standard & Poor's DRI believes the chance of a recession occurring before the end of 2000 now stands at 50-50.

Indeed, at least one forecaster, David A. Levy of the Jerome Levy Economics Institute at Bard College, thinks the odds of a 1999 recession have risen to 75%.

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