Is a Recession Imminent? (2006-32, 11/24/2006)

Two worth reading from the Federal Reserve Bank of San Francisco: John Fernald and Bharat Trehan: >[Is a Recession Imminent? (2006-32, 11/24/2006)](http://www.frbsf.org/publications/economics/letter/2006/el2006-32.html): The sharp slowdown in housing and the inverted yield curve have led to concerns that the odds of a recession have risen.... Our review of the evidence suggests two conclusions: First, recessions appear difficult to predict; second, while the probability of a recession over the next year may now be somewhat elevated, it does not appear to be nearly as high as the yield curve suggests.... >The yield curve is perhaps the best known of all the indicator models used to predict recessions.... [A] model developed by Wright (2006) that uses information on the term spread and the funds rate... estimates a 47% probability of recession over the next four quarters.... >There is reason to be skeptical about the current high estimate of the probability of recession, because the unusually low rates at the long end of the yield curve are not well understood.... >[T]he ability of the yield curve to forecast recessions is often attributed to the fact that the long-term rate reflects market expectations about future developments in the economy. But in that case, one would expect professional forecasters to have this information as well, leading to survey probabilities similar to those from the yield curve. At a minimum, forecasters should be incorporating information from the yield curve into their forecasts... And Michele Cavallo on the carry trade and the failure of uncovered interest parity: >[Interest Rates, Carry Trades, and Exchange Rate Movements (2006-31, 11/17/2006)](http://www.frbsf.org/publications/economics/letter/2006/el2006-31.html): The U.S. dollar has seen some remarkable swings.... Many observers have related these swings to what is known as the carry trade... investors in international financial markets... exploiting the existence of interest rate differentials across countries. >The use of this strategy by investors is puzzling, as the theory of interest parity conditions implies that it should not generate predictable profits.... [A]n investor borrows a given amount in a low-interest-rate currency (the "funding" currency), converts the funds into a high-interest-rate currency (the "target" currency) and lends the resulting amount in the target currency at the higher interest rate.... >According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits.... [T]he difference in interest rates between the two countries [should] simply reflects the rate at which investors expect the high-interest-rate currency to depreciate.... In practice, however, investors in international financial markets do seem able to make profits through such strategies. In fact, market participants and commentators have often cited the carry trade as the source of several recent exchange rate swings.... >If the carry trade is a risky strategy, why are investors reported to use it extensively? The answer lies in the "forward premium puzzle."... Currencies that ... have a low interest rate... tend, on average, to depreciate, not appreciate.... [C]urrencies that... have a high interest rate, tend, on average, to appreciate, not depreciate.... >Burnside et al. find that, for the period from 1977 to 2005, the realized cumulative return to their [carry trade] strategy is very similar to that of investing in the S&P500 index... [with a] the lower volatility of its returns...