Standard & Poor’s has revised its recession risk forecast to 60% from 50%, despite the new stimulus package and the quicker Fed rate cut. We now expect the Fed to cut rates to 2.5% by the spring.
The data on the economy continue to point downward, but not consistently and not drastically. Our interpretation is that we are at the beginning of a mild recession, which looks, on the underlying fundamentals, to be similar to the 1991 to 1992 downturn.
The weakness in housing is spreading into commercial construction and business equipment spending. The signs of a consumer slowdown are less clear, but the evidence suggests consumers are being squeezed by falling home prices and high gasoline costs.
The freeze in financial markets, however, is showing signs of easing.
The London Interbank Offered Rate (LIBOR) dropped back down to 3.3%, below the 3.5% federal funds rate. LIBOR remains high relative to the three-month Treasury bill rate, with a spread of 93 basis points, but that is half what it was three months ago. Moreover, much of the cause is that the T-bill rate is low relative to federal funds, as the flight to quality has cut government bond yields.
Quality spreads remain high, with speculative-grade corporate bonds trading 660 basis points above equivalent Treasuries. Again, this is in part due to the low Treasury yields, with the 10-year at 3.7%. But the cost of funds to all but the highest-rated borrowers remains far above where it was in the middle of last year.
Mortgage rates have dropped down to the lowest level since 2004, with the 30-year conventional rate at 5.7%. But this only applies if the borrower qualifies for a conventional loan. Jumbo mortgages, even for prime borrowers, are running a percentage point above conventional mortgages, compared with a normal spread of about 25 basis points. The stimulus package contains some help for the jumbo market.
Besides capital spending, the major offset to last year’s housing weakness was the improvement in the trade deficit. With Europe and Japan showing weaker growth, exports are likely to slow in 2008. However, the dollar remains weak, and we expect the deficit to continue to narrow — just not as much as in 2007.