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Does the Big "R" Lie Ahead?

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On nothing is there more uncertainty than on the severity and length of the downturn in the U.S. economy.

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Does the Big R (recession) lie in store for the U.S.?

For culinary delight and extreme hospitality, the Big Easy (New Orleans) ranks top of the log. But these attributes are of little use when trying to figure out the lie of the U.S. economic land. For help on this front I have turned to the speakers at the annual New Orleans Investment Conference, where I have been spending the past few days.

Words of wisdom were plentiful, but in reality it came down to "so many people, so many views". And on nothing is there more uncertainty than on the severity and length of the downturn in the U.S. economy. The question in short is: What are the chances of the U.S. economy going into a recession (i.e. two consecutive quarters of negative GDP growth) over the next few months?

But whereas many of the conference speakers are not financially on the hook for their economic forecasts, one can in fact glean some guidance from a market where real money is being wagered on the odds of a U.S. recession. This is the relatively unknown futures market in financial indicators run by Intrade.com.

Trading volumes are low, but contract prices nevertheless give an indication of how punters see events unfolding. According to the latest trades, the chances of the U.S. economy hitting a recession in 2007 are 3.2%, with this figure rising to 38% when it comes to 2008.

The chart below shows the price history of the 2008 contract, and specifically how the odds of a recession almost doubled since the Fed's discount rate cut on August 17, but then again halved since the 50 basis points reduction in the Fed funds rate on September 18. It is only during the last few days that the odds started creeping up again on the back of a realization that the fallout from the sub-prime debacle could hold more bad news.


Click here to enlarge.


And with a meeting of the Fed's Open Market Committee (FOMC) around the corner on October 31, what does Intrade.com say about the outlook for the Fed funds rate? It offers a series of contracts betting that the rate will be on or above certain levels by December 31, 2007. The latest trades are:

≥3.75%: 98%
≥4.00%: 97%
≥4.25%: 95%
≥4.50%: 58%
≥4.75%: 33%

Interpreting the table, the figures suggest a 67% chance of the Fed funds rate being lower than the present 4.75% by December 31, implying at least a 25 basis points reduction. The odds of a larger than 0.25% cut are put at 42%.

Back to the chances of a U.S. recession. My good friend and business partner John Mauldin argues for a "slow-motion recession" – GDP growth in the order of 1% for four quarters. I am in the somewhat pessimistic camp and put the chances of the Big R making its appearance in 2008 at about 60%. If I have conviction in this figure I should hit the ask price of the Intrade.com double and go long of the futures. Or should I perhaps do a private deal with John over another splendid "Nawlins" dinner?
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No positions in stocks mentioned.
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