March 3, 2006

Volume 24, Number 3

Feature Articles and Resources

• Déjà vu—Are We Headed Towards a Recession?
  • Yield Curve Spread and Recessions
  • Probability of a Recession in 12 Months
  • Movement of the Treasury Yield Curve Over the Past 12 Months

• CBO Provides Long-Term Economic Forecasts
  • When Will FOMC Conclude Its Series of Tightening Moves

• NABE Survey Predicts Fed Will Stop at 4.75 Percent

• Investment-Related Sessions at GFOA’s 100th Annual Conference

• Economic Outlook: Strong Economic Growth Expected in First Quarter
• Panel of Economists: Economic Impact of President's Proposals
• Interest Rate Outlook
• Economic and Interest Rate Data
  • Databank
  • Moving Averages
  • Relative Value Yield Chart

• Performance Benchmarks
  • 10-Bill Index
  • Money Market Fund Index
  • LGIP Index
  • Cash Market Key Interest Rates

Déjà vu—Are We Headed Towards a Recession?

Although most economists are currently predicting little chance of a recession (see “Strong Economic Growth Expected in First Quarter” on page 4), one very accurate economic indicator is starting to produce some troubling warning signals. This economic indicator is the yield curve spread (i.e., the difference between long-term and short-term interest rates). Over the past 12 months, the yield curve has flattened dramatically and has come close to the point of inverting, or having a negative slope. A negative sloping yield curve has accurately predicted nearly every recession since 1960.

This article will look at the yield curve spread as a predictor of recessions.¹ After looking at the historical relationship between the yield curve spread and recessions (see Exhibit 1), the article estimates the current probability of a recession that is suggested by recent interest rate data.

Yield Curve Has Predicted Past Recessions. Historical interest rate data shows that the yield curve has inverted before every recession since 1960. The only false signal was in 1996. Although the negative yield curve in this year was not followed by a recession, it was followed by a “credit crunch and a marked drop in industrial production.”2 It is important to note that for the yield curve to be a strong signal of a future recession, the inverted yield curve must last for a month or two. In other words, a brief inversion for a few days or a week may not signal a recession. Exhibit 1 shows how the spread between the 10-year and three-month Treasury turned negative before the last two recessions.

Exhibit 1: Yield Curve Spread and Recessions

The link between the slope of the yield curve and future economic growth is not a coincidence that occurred in recent years. In fact, Michael Bordo of Rutgers University and Joseph Haubrich of the Federal Reserve Bank of Cleveland looked at historical data and found that the yield curve also predicted the future course of the economy during the past 125 years.³

Current Data May Be a Warning Signal. Exhibit 2 shows the probability that a recession will occur in 12 months. As the yield curve has flattened over the past several months, the probability of a recession has increased to greater than 20 percent and has moved closer to the shaded region. Since 1960, whenever the probability has entered the shaded region, a recession has followed within a year. In other words, the probability does not need to be 100 percent in order for a recession to occur. In fact, data from past recessions show a recession occurred whenever the probability was greater than 30 percent.

Exhibit 2: Probability of a Recession in 12 Months

This exhibit is based on a statistical analysis by Arturo Estrella of the Federal Reserve Bank of New York. Estrella used historical data to estimate the probability of a recession at different interest rate spreads. As the spread between the 10-year Treasury note and the three-month Treasury bill decreases and becomes negative, the probability increases that a recession will occur in 12 months.

It is worth noting that many economists, including those at the Congressional Budget Office (CBO), do not think that the current narrowing of the yield curve spread is a signal that a recession will occur in the next few years. The CBO suggests that the narrowing of the yield curve is the result of downward pressure on long-term interest rates caused by other factors that do not foreshadow a future recession. These other factors include heavy foreign demand for U.S. Treasury securities and increased global competition leading to lower future inflation.

Exhibit 3: Movement of the Treasury Yield Curve Over Past 12 Months

¹ This article is based on the following two articles by Arturo Estrella of the Research and Statistics Group at the Federal Reserve Bank of New York: “The Yield Curve and Recessions,” The International Economy, Summer 2005 and “The Yield Curve as a Leading Indicator: Frequently Asked Questions,” October 2005.

CBO Provides Long-Term Economic Forecasts

The U.S. economy will continue to grow at a healthy pace in 2006 and 2007, according to the latest economic forecast by the Congressional Budget Office (CBO). This article will highlight the CBO’s medium and long-term forecasts of economic growth, inflation, and the U.S. federal budget.

Economic Growth and Inflation. The CBO expects the economy to grow at a moderate pace with low inflation. According to the CBO, real GDP will grow at 3.6 percent this year and 3.4 percent in 2007. Over the long term, the CPO projects that real GDP will slow to an average annual rate of 3.1 percent from 2008 to 2011 and 2.6 percent from 2012 to 2016. The CBO also expects low inflation over the long term, with the consumer price index averaging 2.2 percent from 2007 to 2016 (see Exhibit 1).

U.S. Federal Budget Outlook. The total U.S. federal deficit should disappear by 2012 based on the CBO’s most recent projection. The CBO forecast projects that the current total deficit (which is about 2.6 percent of GDP) will decline gradually to 1.4 percent of GDP by 2010, and then in the next two years, quickly turn to a small surplus of 0.2 percent of GDP.

One important assumption in this projection is that Congress will not change various tax increases scheduled to kick in around 2010. If these tax increases occur as scheduled, federal revenues will jump by nearly 9 percent in 2011 and 7.6 percent in 2012. This jump in revenue would erase the total deficit. The “total deficit” figures referred to here combine the “on-budget” deficit with the “off-budget” surpluses in the Social Security trust fund.

Although the total budget is projected to have a small surplus from 2012 to 2016, the CBO warns that after this period the U.S. economy will not be able to keep pace with the growth in Social Security, Medicare, and Medicaid spending. For the federal government to maintain fiscal stability in the coming decades, it will have to substantially reduce the growth of spending in these programs or increase tax revenue as a percent of GDP.

NABE Survey Predicts Fed Will Stop at 4.75 Percent

The most recent survey by the National Association for Business Economics predicts solid economic growth in 2006. Below are some other highlights from the survey:

• A substantial share of respondents reported a shortage of skilled labor, pointing to a tightening labor market.
• Employment growth remained very healthy in the fourth quarter. Hiring plans for the next six months match the strongest results of recent quarters.
• Three out of five panelists expect real GDP to grow at an annual rate of three percent or higher in the first half of 2006.
• Most panelists expect that the Federal Reserve Open Market Committee will stop raising the Fed Funds rate at 4.75 percent (see Exhibit 1 below).

Exhibit 1: When Will FOMC Conclude Its Series of Tightening Moves

Investment-Related Sessions at GFOA’s 100th Annual Conference

The upcoming GFOA conference in Montréal, Canada, May 7-10, 2006, will include the following sessions related to investment of operating funds.

Economic Outlook: Hurricanes and Terrorism and Inflation. The current economic expansion has weathered significant shocks, including a devastating hurricane in the Gulf region of the U.S. and high energy costs. In addition, the threat of future terrorist attacks continues to pose significant risks to the economy. What will happen to economic growth, inflation, and interest rates over the next 12 months? In this session, economists provide their forecasts of economic growth, inflation, and interest rates, and highlight the key factors to watch over the next year in both the U.S. and Canadian economies.

Cash Investment Strategies for Today’s Interest Rate Environment. Investors are facing a mature economic cycle and a flattened yield curve. Which money market investment instruments tend to perform best in this environment, and how should public investors shift their investment strategy to match the current economy? In this session, speakers will discuss prudent investment strategies to maximize liquidity and yield in the present interest rate environment.

Advanced Public Funds Investing: A Risk-Return Balancing Act. If you are you a seasoned public investor, this session is for you. Learn about complex investment concepts in the context of portfolio management. Managing your portfolios is a risk-return balancing act. Learn about different risk concepts and ways to measure these. The session will also consider reward metrics. The concept of benchmarks will be introduced and you will learn how selection of an appropriate benchmark is fundamental in accurately gauging your portfolio’s performance. Different portfolio strategies will be outlined including: active, passive hybrid. Additionally, tools such as yield curve analysis and various spread analyses (credit, maturity, sector) will be discussed.

The Investment Portfolio Game: Putting Your Strategies to the Test. This session will include both a discussion of portfolio management techniques and an interactive computer model investment portfolio game that will allow attendees to apply these techniques. Participants will be divided into teams, each of which will develop a portfolio strategy. Each team will have the opportunity to develop an investment portfolio that will be subjected to unknown market conditions. The team with the best total return wins. This game illustrates the concepts of duration, total return, market values, and how interest rate changes affect the market value of a portfolio.

Register online for the GFOA conference.

Economic Outlook

Strong Economic Growth Expected in First Quarter

The most recent Federal Reserve Survey of Professional Forecasters predicts that the U.S. economy will grow strongly in the first quarter of 2006 with real GDP growth of 4.4 percent. The forecasters expect that economic growth will moderate to 3.2 percent by the end of the year. The survey predicts that GDP will average 3.2 percent in 2007. Over the next 10 years, the forecasters predict that GDP will grow at an average annual rate of 3.2 percent. On average, the forecasters state that there is a 17 percent probability of a recession in 12 months.

According to the forecasts in the survey, the unemployment rate will remain low at 4.8 percent in 2006. The forecasters expect that consumer price index (CPI) inflation will decline to 2.4 percent in 2006 and 2.3 percent in 2007. Over the next 10 years, the survey predicts that the CPI will average 2.5 percent.

The forecasters predict a gradual rise in long-term and short-term interest rates. The three-month Treasury bill is expected to rise to 4.7 percent by midyear, and then remain near that level until the beginning of 2007. The 10-year Treasury note is expected to rise to 5.0 percent by the first quarter of 2007. Over the next 10 years, the survey predicts that the three-month Treasury bill will average 4.25 percent per year and the 10-year Treasury note will average 5.0 percent per year.

Panel of Economists

Economists Provide Forecasts

This month Public Investor asked its panel of economists what effect President Bush’s proposals in his recent State of the Union address would have on economic growth, inflation, and interest rates.

Carl Tannenbaum of LaSalle Bank ABN/Amro states that the President's proposals were very modest. In this election year, the president did not take any aggressive budgetary steps, and did not make any significantly new proposals on health care or entitlement spending. Overall, Tannenbaum does not expect the proposals to have a significant affect on the economy, inflation, or interest rates. John Silvia of Wachovia Securities agrees that the President’s proposals will have very little economic impact.

Peter Kretzmer of Bank of America expects that the President’s proposals will be marginally stimulative on economic growth, which would contribute to real interest rates tilting higher. However, he expects that the Fed would respond to curtail inflationary tendencies.

Gary Thayer of AG Edwards & Sons states that the President’s proposal to reduce dependence on foreign oil could increase research and development of alternative fuels. This could boost economic growth slightly in the near term.

Lacy Hunt of Hoisington Investment Management expects the President’s proposals will have little immediate effect on economic conditions over the next 12 months. However, he predicts that the Fed’s monetary tightening (i.e., 14 consecutive, 25 basis point increases in the Fed funds rate) will contribute to a sharp slowdown in the economy and will cause the Fed to reverse direction in the second half of the year.

Databank

	Current Period	Previous Period	Year Ago
Economic Growth
Real GDP growth	IV Q '05	III Q '05	Year Ago
Annual rate, constant dollars	1.1%	4.1%	3.3%
Retail sales	Jan	Dec	Year Ago
$ billions	365.37	357.00	335.92
Industrial production index	Jan	Dec	12 mo. chg.
Change, monthly and annually	-0.2%	0.9%	3.1%
Leading indicators index	Jan	Dec	6 mo. chg.
Change, monthly and annually	1.2%	-0.2%	1.3%
New housing starts	Jan	Dec	Year Ago
Thousands of units, annualized	2,276	1,988	2,188
Purchasing Management Index	Jan	Dec	Year Ago
Nati'l. Assoc. of Purchasing Management	54.8	55.3	56.3
Inflation
Consumer price index	Jan	Dec	12 mo. chg.
Change, monthly and annually	0.7%	-0.1%	3.44.0%
Producer price index	Jan	Dec	12 mo. chg.
Change, monthly and annually, seasonally adjusted	0.3%	0.6%	5.7%
GDP price deflator	IV Q '05	III Q '05	Year Ago
Annual rate	3.0%	3.3%	2.7%
Unemployment rate	Jan	Dec	Year Ago
BLS	4.7%	5.04.9%	5.2%
Other
Money market fund maturities	Feb 21	Jan 24	Feb '05
Average portfolio maturity (Money Fund Report Averages TM)	40 days	36 days	36 days

6-Month Treasury Bill
2-Year Treasury Note
10-Year Treasury Note

Performance Benchmarks

Quarterly/Monthly
Return