Monday, November 14, 2011

A Tale of Two Forecasts

Let’s take a quick look at the probability of a US recession in 2012. Here are forecasts from two sources that have little to do with one another. The first one comes from the FRBSF Economic Letter (the San Francisco Fed). Using a set of leading economic indicators (LEI) they put the probability of a recession close to 55% at the peak this coming January. 

"The combination of these two recession coins, shown in the combined risks line of Figure 2, is quite disconcerting. It indicates that the odds are greater than 50% that we will experience a recession sometime early in 2012."

Source: FRBSF

That’s in two months!

The competition for the Fed's forecasting prowess is Intrade, the event betting site. Its a market implied probability of a recession in 2012, forecasting 38% probability. 

In the past one could observe the LIBOR futures curve dipping down or the inverted treasury curve as market implied evidence of an impending economic downturn. These days the Fed is keeping short-term rates near zero and is “twisting” the treasury curve. Thus these markets no longer function as an indicator, and something like Intrade becomes one of the few remaining market based forecast tools. One may argue that those betting just don’t know what they are doing. If that is so, go ahead and bet against them.

So who is right? We should know within a few months.
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