December 14, 2007 / 7:06 PM / 12 years ago

Not sure about recession? Look to U.S. bond market

NEW YORK (Reuters) - The warning signs of recession have been flashing in the bond market and may show officials are already too late to prevent the economic rut they have been scrambling to avoid.

Traders in the 10-year bond options pit of the Chicago Board of Trade signal orders in Chicago December 11, 2007. The warning signs of recession have been flashing in the bond market and may show officials are already too late to prevent the economic rut they have been scrambling to avoid. REUTERS/Frank Polich

Before the Federal Reserve banded together with central banks this week to end the global credit crunch, a closely watched beacon of financial distress known as the “TED spread” was broadcasting its own “danger” alert.

Even earlier, an inverted yield curve, one of the oldest bond market omens of recession, had already predicted trouble. That was months before the White House dreamed of bailing out mortgage borrowers or banks thought they might save bad investments with a super fund.

“I think that we’re either in a recession or headed for one,” said David Coard, head of fixed-income sales and trading at the Williams Capital Group.

The problem with recessions — traditionally defined by two consecutive quarters of economic contraction — is that it’s difficult to know one has occurred until it’s nearly over.

One factor making economic bears such as Coard cautious about declaring a recession now is that reports have not sent a convincing signal, noting Thursday’s robust retail sales data.

But, they say, it’s only a matter of time, and there are indicators for those willing to heed them. Meanwhile, Friday’s strong inflation numbers could complicate the dilemma facing the Federal Reserve in dealing with any slowdown.

JUST ASK TED

One key short-term indicator is the TED spread, or Treasury-Eurodollar spread. This measures the difference between three-month yields on “safe-haven” Treasury bills and the comparable London interbank offered rate, a benchmark for interest on loans between banks.

The TED spread increases during financial or economic disruption, such as the turmoil in the wake of this year’s U.S. mortgage meltdown.

Currently above 210 basis points, it is particularly high and reflects reluctance among banks to lend money to each other. Ultimately, this could choke off the economy.

“A high TED spread is a sign of an elevated risk that the economy is in or might be about to enter, a recession,” Goldman Sachs said in a research report.

William O’Donnell, head of U.S. interest rate strategy and research at UBS in Stamford, Connecticut, said the TED spread reflected a “huge amount of distress” and said there are signs this tension in the money market could continue for some time.

This runs counter to the view that markets will calm after the New Year, since November and December accounting issues are known to make banks tight-fisted even in normal times.

Instead, it suggests banks may struggle for much of next year to digest this year’s losses, cutting into their ability to lend to the broader economy.

“Meanwhile, the recession risk grows daily,” said O’Donnell.

AHEAD OF THE CURVE

A longer-term recession signal, the yield curve of U.S. government bonds inverted late last year and remained out of kilter well into the first half of 2007.

The curve represents the yields of short-term and long-term U.S. Treasuries. Long-term rates are usually higher than short-term yields, except in times of economic stress.

Similar inversions spelled trouble in the past.

“We were in there for a good long period of time and I think it’s important to note that every recession of the last 50 years has been preceded by an inverted curve,” said O’Donnell.

In many cases the yield curve had returned to a positive slope or was nearly there before the onset of recession.

Despite the ominous signs, economists generally are not predicting a recession, based on the median forecast in a Reuters poll last month.

But don’t put too much stock in forecasters, some would say.

Researchers for the Federal Reserve Bank of San Francisco argue that the yield curve does a much better job of signaling

recession. The add: “Economists have a very spotty track record of predicting downturns.”

Reporting by Burton Frierson; Editing by Dan Grebler

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