Dreaded 'R' word starts tripping off the tongue

Everywhere you turn, recession is staring you in the face.

The Sunday New York Times featured a story on the prospects of recession on the front page of the Week in a review section. The following day, the Wall Street Journal published a recession article on page one.

Across the pond, Harvard's Larry Summers made waves in a November 26 Financial Times column, in which he said "the odds now favour a US recession.'' Newspapers in Europe and Asia are commenting on recession.

Economists are scurrying to pencil in another reduction in the Federal Reserve's benchmark rate on December 11 and to pare their expected target for next year, comments by policy makers notwithstanding.

Less than two weeks ago, Fed Governor Randall Kroszner was surprisingly blunt when he told an industry conference that "the current stance of monetary policy should help the economy get through the rough patch during the next year.'' Data consistent with the expected slow growth won't suggest that monetary policy is "inappropriate,'' he said.

The message was about as clear as it gets when it comes to the central bankers: No rate cut in December. Unfortunately, the market outlook isn't aligned with the Fed's forecast.

The fed funds futures market is placing the odds of a 25- basis-point cut on December 11 at 98 per cent. Economists had initially put their faith in the Fed's words. Now they're siding with the market's action.

Markets Talk
So is all this recession talk overblown, a good story to explain teetering world stock markets? What is the hard evidence that the economy is rolling over?

"The thing that makes it most compelling is the consensus of economists on growth,'' says Paul Kasriel, director of economic research at the Northern Trust in Chicago.

For those putting their faith in the markets, one glance at the US Treasury yield curve tells you that something is amiss. The yield on every issue, from bill out to bond, is below the Fed's target rate.

That's an unnatural state of affairs that violates Rule No. 1 of banking: borrow short, lend long. It makes it harder to turn in a profit, which is one of the reasons that financial stocks have been the biggest losers this year.

The spread between the funds rate and 10-year treasury yield, which is one of 10 components in the Index of Leading Economic Indicators, has been inverted since July 2006 on a monthly average basis.

Considering that the US economy was still expanding in the third quarter "" at close to a 5 per cent "" the spread's lead time looks to be long if estimates about tomorrow's revision are correct.

Credit Spreads
All the talk about why long rates have been low "" dollar- related buying by the People's Bank of China, the global savings glut and now a panicked flight-to-quality "" is beside the point. The message of the yield curve is that the Fed is keeping the overnight rate too high relative to the market-determined long-term rates.

There are other troublesome signals emanating from the market. The spread between high-yield bonds and gilt-edged government securities has more than doubled since June to about 500 basis points.

"Credit spreads are usually a coincident to lagging indicator,'' Kasriel said. "The fact that they've widened may suggest we're already in'' recession. The three-month interbank lending rates are rising, and central banks in both the US and Europe are acting to ease the anticipated year-end funding pressures.