By Daniel Kruger
March 12 (Bloomberg) -- Alan Greenspan, who jolted investors by predicting a one-in-three chance of a recession this year, isn't as bearish as the bond market, where the risk of a downturn is even money.
The probability the U.S. economy will shrink for two quarters has risen to 50 percent, according to a model created when Greenspan ran the Board of Governors of the Federal Reserve System. The formula is based on differences in yields on Treasuries.
The economy has gone into recession six of the seven times since 1960 that short-term interest rates topped longer-term bond yields, as they do now. The difference between three-month bills and benchmark 10-year notes is close to the widest since 2001. Investors say the so-called inverted yield curve is a sign the Fed will cut borrowing costs because the economy is decelerating.
``We're going to have slower growth,'' said Barr Segal, a managing director at TCW Group Inc., a Los Angeles-based firm that oversees $80 billion in fixed-income assets. ``The fundamentals of the economy are what you have to watch.''
Investors have used interest rates to predict the economy since 1913, according to a Fed study. Short-term rates have exceeded long-term yields since July, in part because of demand for Treasuries from China and other central banks. The yield difference may now be sending a message about the economy, some investors say.
``The yield curve should not be ignored,'' said Saumil Parikh, who helps manage $688 billion at Pacific Investment Management Co., in Newport Beach, California. ``The fact that the yield curve is inverted gives us a signal that overnight rates are too high. That's what the yield curve is telling the Fed.''
Better Predictor
Treasuries fell last week as the government said the U.S. added more jobs than forecast and stock markets rebounded. The yield on the 4 5/8 percent note maturing in February 2017 rose 9 basis points to 4.59 percent.
A yield-curve model the Fed developed in 2006 is based on research by staff economist Jonathan Wright, as well as analysis from the 1990s by two economists at the Federal Reserve Bank of New York, Arturo Estrella and Frederic Mishkin. Christopher Low, chief economist in New York at FTN Financial, used the model to determine that the 50-basis-point yield gap between three-month bills and 10-year Treasuries would amount to a 50 percent likelihood of a recession over the next year.
Estrella and Mishkin's study said Treasury yields are a better predictor of recessions than stock prices. That's because relatively high short-term rates slow the economy while lower longer-term rates reflect the outlook for weaker growth and inflation, they wrote.
`Imbalances Can Emerge'
Treasury yields may be less of a predictor this time because of demand for U.S. securities from foreign investors, said David Ader, head of government bond strategy in Greenwich, Connecticut, at RBS Greenwich Capital, one of the 21 primary dealers that trade directly with the Fed.
Overseas investors bought $198.6 billion more Treasury notes and bonds than they sold in 2006, up from $18.5 billion in 2001, according to the Treasury Department.
The yield curve has inverted in the past without being followed by recession. In 1966, surging job growth and falling unemployment pushed inflation higher, prompting the Fed to decrease money supply growth and raise the effective funds rate. The flight to Treasuries after Long-Term Capital Management's collapse in 1998 also resulted in an inverted yield curve that failed to be followed by recession.
Economists typically do not consider an inversion of yields significant unless it lasts for three months, Low of FTN said.
`Imbalances Can Emerge'
``We are in the sixth year of a recovery; imbalances can emerge as a result,'' the 81-year-old Greenspan said in a March 5 interview with Bloomberg. ``Ten-year recoveries have been part of a much broader global phenomenon. The historically normal business cycle is much shorter'' and is likely to be this time, he added.
Mishkin, a Columbia University economist, was sworn in as a Fed governor in September. Mishkin and Wright declined to comment. Estrella, a senior vice president in the Research and Statistics Group of the New York Fed, also declined to comment. Greenspan declined to comment.
Three-month bills have exceeded the yield on notes since July 19, three weeks after the central bank raised its overnight lending rate between banks to 5.25 percent, the last of 17 straight increases since 2004. The gap widened to as much as 60 basis points on Feb. 27, the widest since February 2001. A basis point is 0.01 percentage point.
`Severe Monetary Restraint'
``It's an indication monetary policy is biting,'' said Lacy Hunt, chief economist at Hoisington Investment Management Co. in Austin, Texas, which manages $4.8 billion of Treasuries. ``You have fairly severe monetary restraint on the system.''
The Fed's decision to raise rates preceded recessions and contributed to corporate failures including Penn Central Railroad in 1970, Franklin National Bank in 1974, and Continental Illinois National Bank & Trust Co. in 1984, said Hunt, a former senior economist at the Federal Reserve Bank of Dallas.
Greenspan, speaking on a videoconference call to investors in Hong Kong Feb. 26, said slowing growth in profit margins was a sign the expansion might be winding down, according to the Associated Press. Treasuries rose the most since December 2004 and stocks fell the most since 2002 the next day.
Greenspan was ``being cautious,'' said Low of FTN, who expects the economy to grow 1.5 percent to 2 percent in 2007. ``He was saying in a roundabout way that Fed policy is tight.''
`Pace Is Moderating'
On Feb. 28, Fed Chairman Ben S. Bernanke said the central bank expects the economy to pick up. There's little indication that subprime mortgage defaults have spread, Bernanke told the House Budget Committee.
The Fed says the economy to grow 2.5 percent to 3 percent this year and 2.75 percent to 3 percent next year, according to forecasts presented to Congress last month.
``The economy's growth pace is moderating and will probably grow below potential,'' said Tony Rodriguez, who oversees $70 billion as head of fixed income at FAF Advisors in Minneapolis, the asset-management arm of U.S. Bancorp. Treasury yields are ``pointing toward an economy that's moderating.''
To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net
Last Updated: March 12, 2007 10:54 EDT
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