A paper titled “The Yield Curve and Predicting Recessions”, by Jonathan Wright, research economist at the Federal Reserve, describes the probability of an economic recession as a function of the spread between the yields on 10-year and 3-month U.S. Treasury securities (see However, Wright and other researchers suggest that in addition to the spread it is helpful to look at the overall level of short term interest rates. Wright’s Model uses both the spread (S) and the funds rate (R) to calculate the probability, where F denotes the cumulative distribution function for a standard Normal variable, so: Prob = F(-2.17 – 0.76 x S + 0.35 x R). The probabilities implied by different values of S are summarized in the table below:

Probability of recession within the next 4 quarters (in percent) as a function of both the spread between 10-year and 3-month yields and the level of the fed funds rate.

Spread FF = 3.5 FF = 4.0 FF = 4.5 FF = 5.0 FF = 5.5
1.00 4% 6% 9% 12% 16%
0.75 6% 9% 12% 16% 21%
0.50 9% 13% 16% 21% 27%
0.25 13% 17% 22% 27% 33%
0.00 17% 22% 28% 34% 40%
-0.25 23% 28% 34% 41% 48%
-0.50 29% 35% 41% 48% 55%
-0.75 35% 42% 49% 56% 63%
-1.00 43% 50% 57% 63% 70%

Thus, right now, it would seem that the probability for recession in the US is less than 48% (if you look at the graph below, S is between -0.25 and 0.0). But, if you go back forty years on this measurement, you will notice that every time the spread has dropped below zero or by more than 3 percent from its previous high, there has been a recession (gray line).


In our opinion, it is likely that we are getting to the point where a recession may be in the cards. This would add influence to the argument, first posted in our “NEWS FROM DUBAI” article of July 6th, that oil maybe about to start an important correction. Based on the graph posted then (DSE moves precede oil-prices by 2-3 months), we might see oil prices dropping substantially.  As expressed in today’s WSJ (article below) by Mr. Philip Verleger, an independent energy economist who heads PK Verleger LLC, “If the economy slows and demand for petroleum eases, investors will scramble for the exits.” Medium term, though, we do not agree with Mr. Verleger, we think 2007-2008 may be years to reposition in oil, once the markets correct as expected.


Single-Digit or $100 Barrels?

The Answer Probably Depends

On Impact of Investment Flows


August 21, 2006; Page C1

A nearly 8% decline in crude-oil prices in the past two weeks, and the market’s flirtation Friday with prices below $70 a barrel, is reigniting a debate: Is there an oil-price bubble, and could it burst?

Underlying the question is an argument about what has been a bigger factor buoying oil prices in the first place: record investor inflows into commodities or supply-and-demand fundamentals.

The answer will go a way toward setting the tone for broader financial markets and the economy. High oil prices have affected everything from consumer spending, to the stock and bond markets, to interest-rate increases by the Federal Reserve to curb inflation.

If oil continues to slide even as international tensions flare, “it is going to be much more difficult to argue that crude oil remains a bull market and that all dips are buying opportunities,” says Tim Evans, a futures analyst with Citigroup Inc.

Crude-oil futures contracts for near-month settlement on the New York Mercantile Exchange surged more than 33% over nearly six months, hitting $76.98 a barrel on Aug. 7 before falling to a two-month low Thursday of $70.06. After an intraday low of $69.60 Friday, near-month crude-oil prices bounced back to settle at $71.14 a barrel on news of a storm developing in the Gulf of Mexico.

As prices soared earlier in the summer, oil analysts and economists argued that global economic growth, tight refining capacity to process crude oil into usable products like gasoline, and geopolitical tensions could push crude beyond $80 a barrel, even as oil inventories remained high in the U.S.

These specialists dismiss the notion that crude’s recent pullback is a turning point. Instead, they point to short-term factors that have pushed oil lower, including a move by Goldman Sachs Group Inc. this month to reduce its exposure to gasoline in the widely watched Goldman Sachs Commodity Index.

In addition, they say BP PLC’s Alaska pipeline shutdown had less of an impact on oil supplies than initially feared. Seasonal factors also play a role, including a lighter-than-expected hurricane season, the ending of the summer driving season and the expected drop in demand for crude from refineries as they shift operations for winter-grade fuels.

“Until I see massive spare capacity in Saudi Arabia or new refining capacity in Asia or the Middle East, the world will still be susceptible to the same exogenous shocks as it has been in the last three years, whether the shocks are from civil strife, geopolitics or weather,” says Edward Morse, chief energy economist for Lehman Brothers Holdings Inc. He says global demand remains robust.

Still, an increasing number of analysts and traders predict that oil prices are poised for further decline. They say the market has become somewhat inured to geopolitical uncertainty — reacting to the news of another kidnapping of oil workers in Nigeria, for example, with a 25-cent jump, when the price used to move $2 on such events.

Traders say prices are high considering some key supply-and-demand indicators. Mark Vonderheide, global head of oil trading for Deutsche Bank AG, points to a large buildup in world inventories. Traders are “balancing the fundamental weakness of this market against the probability of some global event or continuation of global events in Nigeria, Iran or Venezuela….Barring an event, it’s very likely we’re headed for much lower oil prices.”

Oil prices may at least level off a bit, some energy researchers say. Larry Goldstein, president of the Petroleum Industry Research Foundation, calls the recent slide in prices “a move to a new equilibrium level, not the start of a major selloff.”

Some increasingly vocal bears are making stark forecasts. Sanford C. Bernstein & Co. energy analyst Ben Dell is calling for $50 crude in early 2007. Philip Verleger, an independent energy economist who heads PK Verleger LLC, predicts in an interview that oil could hit the single digits in the next three years.

In particular, they say, the market hasn’t fully grasped the import of investment flows into oil futures and the danger that a slowdown in those investments could cause a lull or even a panic in the oil markets. Institutional money managers have $100 billion to $120 billion in commodities, at least double the amount three years ago and up from $6 billion in 1999, says Barclays Capital, the securities unit of Barclays PLC. Mr. Dell estimates such investors have $40 billion invested in crude alone.

“Too much money has been chasing too few commodities futures,” Mr. Verleger argues. He says that as long as economic growth continues, oil could climb as high as $100 a barrel in the fourth quarter of 2007. If the economy slows and demand for petroleum eases, investors will scramble for the exits. “There is no floor. The price could fall to single digits. It won’t stay there for very long, but it could fall.”

Mr. Verleger’s dramatic forecast isn’t shared by most analysts. Still, the impact of investment flows into commodities has taken some in the oil establishment off guard. As oil prices steadily rose to triple their levels three year ago, ministers from the Organization of Petroleum Exporting Countries, oil-company executives and others have periodically argued that the fundamentals of supply and demand didn’t justify the increase.

Deutsche Bank’s Mr. Vonderheide says the inflows into index-related oil investments are a big-enough factor that, if they slow, the market could fall further.

In the days leading up to and just after Goldman’s Aug. 9 announcement that it was reducing its allocation to gasoline contracts in its index, gasoline futures took a dive.

Write to Ann Davis at and Bhushan Bahree at






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