(Adds Goldman strategist forecast on fifth screen.)
Oct. 11 (Bloomberg) -- The bond market indicator that has predicted every U.S. recession since 1970 shows that the economy has about a 60 percent chance of contracting within 12 months.
The so-called Treasury yield curve, adjusted for distortions caused by the Federal Reserve’s record low zero to 0.25 percent target interest rate for overnight loans between banks, shows that two-year notes yield 20 basis points, or 0.20 percentage point, less than five-year notes, according to Bank of America Corp. research. The unadjusted gap of 79 basis points at the end of last week indicates the chance of recession at about 15 percent.
Short-term rates have been higher than longer-term yields, or inverted, before each of the seven recessions since 1970. A contraction would make it harder for U.S. President Barack Obama to reduce unemployment, which has held at or above 9 percent every month except two since May 2009, including a reading of 9.1 percent in September. It may also help bolster Treasuries and keep yields near all-time lows.
“The adjusted curve is giving a powerful signal for an upcoming U.S. recession,” said Ruslan Bikbov, a fixed-income strategist in New York at Bank of America, one of the 22 primary dealers of U.S. government securities that trade with the Fed. “If that happens, the Fed’s target rate could remain near zero beyond 2014,” more than a year longer than the central bank has indicated, he said in an interview on Oct. 3.
‘Close to Faltering’
Bank of America’s research is sending the same message as the Economic Cycle Research Institute and Bill Gross, manager of the world’s biggest bond fund, which say the U.S. may be headed into a decline. Fed Chairman Ben S. Bernanke said last week in testimony to Congress that the central bank can take further steps to sustain a recovery that’s “close to faltering” after almost three-years of near-zero interest rates and $2.35 trillion of bond purchases.
The Organization for Economic Cooperation and Development cut its forecasts for the U.S. last month, saying the $15 trillion economy likely grew 1.1 percent in the third quarter and will expand just 0.4 percent in the fourth.
Data last week showed some signs of strength, damping the appeal of government debt. The Institute for Supply Management’s factory index climbed to 51.6 last month from 50.6 in August, the Tempe, Arizona-based group said Oct. 3. A level of 50 is the dividing line between growth and contraction. The median forecast of 82 economists surveyed by Bloomberg News projected a drop to 50.5.
The yield on the benchmark 10-year Treasury rose 16 basis points last week to 2.08 percent, the biggest gain since it increased 32 basis points in the period ended July 1. The yield is up from 1.6714 percent on Sept. 23, the lowest since at least 1953. The two-year note yield ended last week at 0.29 percent, and the five-year security’s at 1.08 percent.
Ten-year notes yields rose to 2.17 percent as of 10:28 a.m. in New York, while two-year rates were 0.30 percent and five- year notes yielded 1.15 percent.
Yields on five-year Treasuries exceed two-year notes by 83 basis points. While that is above the low this year of 58 on Sept. 22, the gap has shrunk from a high of 156 on Feb. 10.
The difference would be even narrower if not for the fact that interest rates can’t fall below zero, the current low absolute level of yields and the relatively high volatility in bond markets, according to Bank of America. The bank’s forecasting model removes these conditions, allowing it to better compare the current yield curve with that of past periods of slow economic growth.
Bank of America sees 10-year note yields at 2.3 percent by year-end, and two-year yields at 0.2 percent, according to data compiled by Bloomberg.
“The yield curve wouldn’t really invert now due to technical reasons, mainly as most banks’ models don’t allow projections of interest rates in the future to be zero or below,” said London-based Moorad Choudhry, head of business treasury, global banking and markets at Royal Bank of Scotland Group Plc in an interview on Oct. 4. “These are special circumstances, with the Fed’s target rate at zero.”
The Fed cut its benchmark rate to near zero in December 2008 after a housing boom turned into a subprime-mortgage bust, driving Lehman Brothers Holdings Inc. into bankruptcy three months earlier and freezing global credit markets. The economy slipped into a recession at that time that lasted 18 months before a recovery began.
Goldman Sachs Group Inc., another primary dealer, puts the odds of another recession at 40 percent, the firm’s economists wrote in an Oct. 3 report. Francesco Garzarelli, co-head of fixed-income strategy at Goldman Sachs in London, wrote in an Oct. 4 note that their bond valuation model, using the firm’s most recent economic forecasts, now indicates 10-year Treasury yields will end the year at 2.7 percent from a previous 3.1 percent level. Given the model’s projections combined with other factors, Garzarelli predicts 10-year yields will end 2011 at 2.25 percent, compared with a previous estimate of 2.75 percent.
JPMorgan Chase & Co. economists said in an Oct. 7 report that they see “a soft growth picture, but one that is not falling into recession at the moment.” The firm, also a primary dealer, forecasts the 10-year note yield will end the year at 2.25 percent.
“We are in a world of lower growth expectations, but that said, the long end of the curve is actually too flat now relative to where it should be,” said Srini Ramaswamy, a New York-based analyst on JPMorgan’s fixed-income research team. “Given our models, which factor in our expectations for things including economic growth, we find the recent flattening of the yield curve as overdone,” he said in an Oct. 4 telephone interview.
The difference in yields between 10- and 30-year Treasuries, the area Ramaswamy is referring to, was 92 basis points, down from this year’s peak of 147 on Aug. 12. The 30- year yield plunged below 3 percent last month for the first time since 2009, before touching 3.06 percent today.
Three-month Treasury bill rates have topped 10-year yields eight times since 1960, with recessions following in six of those cases. There hasn’t been a contraction that wasn’t preceded by a so-called inverted curve in that period.
The three-month bill to 10-year note spread is at 213 basis points. Federal Reserve Bank of Cleveland researchers Joseph Haubrich and Margaret Jacobson wrote in a report posted on the bank’s website on Sept. 30 that they estimate the chances of the economy’s being in a recession next September is 7 percent, up from 4.8 percent in August and 1.7 percent in July.
A “contagion” of economic indicators have come together to signal the economy is tipping into a contraction, according to Lakshman Achuthan, co-founder of ECRI, a research firm that predicts changes in the economic cycle.
“You have wildfire among the leading indicators across the board,” Achuthan said in a radio interview on Sept. 30 on “Bloomberg Surveillance” with Tom Keene and Ken Prewitt. “It’s a vicious cycle that is going to get quite a bit worse.”
While the Labor Department said Oct. 7 that employers in the U.S. added 103,000 workers to payrolls in September, sustained jobs growth of about 150,000 a month is needed to reduce unemployment by about half a percentage point over a year, according to Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York.
The world economy risks lapsing into a recession with the pace of growth falling below the “new normal” level Pacific Investment Management Co. has predicted since 2009, Gross wrote in a monthly commentary posted on the Newport Beach, California, firm’s website Oct 3. Pimco’s “new normal” scenario says that following the market’s collapse in 2008 the U.S. economy would grow at a below-average pace for several years.
“Markets these days give mild signs of a collapse,” Gross said in an Oct. 4 Bloomberg Television interview with Lisa Murphy. The odds of recession in developed economies is about 50 percent, with the U.S. on the “brink,” he said. “This is one of those times where you are worried about the return of your money.”
After eliminating Treasuries from his $245 billion Total Return Fund in February because they were too expensive, Gross increased holdings of U.S. government securities to 16 percent of assets as the debt had the highest quarterly returns in almost three years.
Treasuries returned 6.4 percent in the third quarter, the most since the depths of the financial crisis in 2008, according to Bank of America Merrill Lynch indexes. Stocks tumbled, with the Standard & Poor’s 500 Index falling 14 percent, the biggest quarterly drop since the last three months of 2008.
Equity traders are boosting bearish trades around the world by the most in at least three years. Borrowed shares, an indication of short selling, have risen to 11.3 percent of stock available for lending from 9.5 percent in January, according to data compiled for Bloomberg by the London-based research firm Data Explorers.
“Half the people you speak to tell you they already think we are in a recession,” said Jeffrey Gundlach, chief executive officer of Los Angeles-based DoubleLine Capital LP, which manages $17 billion, during a panel discussion the firm held for clients on Sept. 29 in New York. “There remains no real fundamental reason in the U.S. for interest rates to go higher.”
--With assistance from Lukanyo Mnyanda in Edinburgh. Editors: Philip Revzin, Dennis Fitzgerald
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