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Dividend Swaps Signal No Slowdown as European Crisis Boils

Investors don’t see a U.S. recession in the next 12 months, based on dividend swaps that indicate consumption of services may grow 1.8 percent by November 2012.

The annualized forecast as of yesterday held in the 11-month range of 1.8 percent to 2.2 percent, according to the four authors of a National Bureau of Economic Research report. They derived the estimates using “standard forecasting techniques” to calculate equity yields from dividend-swaps contracts, said Jules van Binsbergen, a faculty research fellow at the NBER and one of the authors.

“Equity yields are not predicting a double-dip recession, but rather a continuation of modest growth,” said van Binsbergen, an assistant professor at Northwestern University Kellogg School of Management in Evanston, Illinois, and Stanford University Graduate School of Business in California.

Dividend swaps, which are traded over-the-counter in the U.S. for the Standard & Poor’s 500 Index, offer “very valuable” information about consumption-growth expectations because they are “very responsive to what’s happening in the real economy,” said Evert Vrugt, a Singapore-based quantitative trader at Invenio, part of Olam International Ltd., who bought and sold dividend contracts when he worked at Amsterdam-based APG Asset Management. Services account for about 66 percent of total consumption, van Binsbergen said.

Moderated Expectations

The expectations have moderated from April’s 2.2 percent implied growth rate, partly because of concerns that the European debt crisis and U.S. deficit debate would hamper the recovery, according to co-authors Vrugt and Ralph Koijen, assistant professor at the University of Chicago Booth School of Business. Actual services-consumption growth for the past 20 years has averaged 2.4 percent, van Binsbergen said.

The price at which S&P 500 dividend swaps are currently trading reflects “some growth,” which is “quite constructive given the macro fear of a slowdown,” said Kokou Agbo-Bloua, a senior equity and derivatives strategist at BNP Paribas SA in London. The contracts are “definitely attracting a lot of interest” from a broad base of investors and provide a “more detailed and real-time view of market expectations with respect to company earnings and economic growth,” Agbo-Bloua said.

U.S. gross domestic product expanded 2.5 percent in the third quarter after growth of 1.3 percent and 0.4 percent in the previous two quarters.

Forecasting Alternative

The dividend-swaps contracts offer a forecasting alternative to the so-called Treasury yield curve, which requires an adjustment for distortions caused by the Federal Reserve holding its benchmark interest rate at a record low zero to 0.25 percent since December 2008, said Koijen, who is also a faculty research fellow at the NBER.

In a dividend swap, the buyer agrees to pay in the future fixed cash amounts that both parties agree upon today, while the seller commits to pay the realized dividends on the S&P 500 Index at the end of the period.

The Fed’s interest-rate policy has made the link between short-term interest rates, inflation and growth unstable, Koijen said. That means the Treasury bond yields have to be adjusted because nominal rates are rarely negative -- or fall below the “zero lower bound” -- whereas equity yields “swing from negative to positive,” he said.

The central bank said yesterday there are “significant downside risks to the economic outlook.” It left unchanged its pledge to keep the target for the rate on overnight loans among banks at “exceptionally low levels” through at least mid-2013, as long as unemployment remains high and the inflation outlook stays “subdued.”

Fewer Jobless Claims

Fewer Americans filed applications for unemployment benefits in the week ended Oct. 29, as jobless claims fell by 9,000 to 397,000, the fewest in a month, the Labor Department said today.

While the dividend-swaps contracts provide an additional source of information to monitor growth expectations, there isn’t as much history for the predictability of these contracts because they’ve traded for only about 10 years, van Binsbergen said. The dividend-swaps market has become “increasingly liquid,” he said, while the Treasury bonds market is one of the world’s most active.

There also may be a slight lag when investors estimate growth using the dividend-swaps market. Consumption-growth forecasts held at 0.8 percent in September 2008, matching the prior month, even amid turbulence in financial markets that included the collapse of Lehman Brothers Holdings Inc. In October 2008, the growth projections went negative for the first time; they turned positive again in June 2009. That’s when the 18-month recession ended, according to the NBER.

Allocating Risk

Investing in dividend swaps is one way APG Asset Management allocates risk, said Wouter Hueskes, who co-wrote the paper and actively trades these contracts as a senior portfolio manager for the firm’s absolute return fund.

“The current expectations are in line with what we saw before this summer’s debt concerns,” van Binsbergen said. They’re “on par with a moderate growth scenario.”

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