The Bank of England’s “other assets” rose by £1.1 billion in the week to 21st November, down from £2.0 billion in the prior week. The cumulative increase since 12th September is now £26.4 billion, the bulk of which will represent lending to Northern Rock. With Building Societies Association figures earlier this week suggesting a massive outflow of retail funds from the troubled bank (see here), the Rock loan looks on course to reach £30 billion by year-end.

In a post last week I explained that the G7 economic downswing is now a year old and at the critical point that has divided “soft” and “hard” landings historically – see first chart below. I still think a “hard” landing can be avoided, although recent further credit market turmoil and rises in energy costs have obviously increased downside risks.

The chart also shows the developed-markets “revisions ratio” – the net proportion of equity analysts’ company earnings forecasts that are upgraded each month. The revisions ratio is a good coincident indicator of the G7 industrial cycle and is published on a timely basis, with November figures released this week. Unsurprisingly, the ratio is now in negative territory – more forecasts are being downgraded than upgraded – but its level is currently still consistent with a “soft” landing. Further weakness is likely but the ratio needs to fall to -0.10 (i.e. a net 10% of all forecasts cut) to ring “hard” landing alarm bells.

I have argued that the consensus is too fixated with US recession talk and is underplaying downside risks in Europe. This theme receives support from regional revisions ratios, showing notable weakness in continental Europe (and Japan) in the latest month – see following chart. The ECB has been slow to acknowledge a deteriorating outlook but I think policy-makers will soften their stance at the December meeting and signal a possible rate cut in early 2008. This could take some of the steam out of the euro.

Minutes of the November MPC meeting reveal a 7-2 vote for unchanged rates, in line with our MPC-ometer forecast. A minor surprise was that Gieve joined Blanchflower in seeking a cut, while Bean and Lomax – who opposed the last rise in July – voted for stable rates.

The MPC-ometer forecast for December will be available at the end of next week but I think a 25 b.p. cut is likely. Failure to deliver would sit uneasily with the remarkably dovish November Inflation Report, indicating a 50 b.p. decline is necessary to prevent an inflation undershoot. More straightforwardly, three-month LIBOR has risen by 25 b.p. since the last MPC meeting so an official cut is arguably required just to offset market-led tightening.

The retail run on Northern Rock continued apace in October despite government guarantees on deposits, judging from Building Societies Association savings figures released today. Societies attracted a record £3.0 billion of new receipts, up from £2.8 billion in September and just £770 million in October last year. According to BSA Director-General Adrian Coles, “it seems that the majority of these deposits are funds withdrawn from the Northern Rock bank”.

A conservative guesstimate is that building societies enjoyed additional Rock-related inflows of £2.5-3 billion in September and October combined. With societies accounting for 20% of the retail deposits market, this suggests total withdrawals from the troubled lender of £12.5-15 billion for the two months, equivalent to more than half of its £24.3 billion of retail funding at mid-year.

Money supply figures also released today showed monthly M4 growth of just 0.1%, down from 0.9% in September. Details reveal that the drop reflected a fall in “net sterling lending to non-residents”. This is likely to be related to selling of UK securities by foreigners in the wake of the Northern Rock crisis.

One of my “favourite external links” is to the weekly market comment written by US economist and fund manager John Hussman. Hussman has been downbeat on the US economy for some time but has argued there was insufficient evidence to forecast a recession. He now thinks the balance has tipped, as explained in last week’s comment, titled “Expecting a recession”.

Other forecasters and media pundits have also been piling on the gloom recently. The Economist  this week opined that "recession in America looks increasingly likely".

Hussman's approach is admirably empirical. He describes a “rule of thumb” based on four conditions that have been jointly observed in every US recession. The conditions are:

1. A widening of credit spreads from six months earlier.

2. A flat yield curve, defined as longer-term Treasury yields no more than 2.5% above three-month yields.

3. A fall in the stock market from six months earlier.

4. A purchasing managers’ index for manufacturing of 54 or lower coupled with either non-farm employment growth of less than 1.3% over the prior 12 months or a rise of 0.4 percentage points or more in the unemployment rate from its 12-month low.

Conditions 1, 2 and 4 were met in October and condition 3 is likely to fall into place in November – the S&P 500 has averaged 1478 month-to-date compared with 1511 in May. Hussman therefore now believes a recession is immediately ahead.

The economy was much stronger than the bears forecast in the second and third quarters. I have been expecting a sharp slowdown in growth in the fourth quarter but no recession, at least yet. Should I change my view in light of Hussman’s analysis?

I have to concede that his rule of thumb works well historically. There have been eight US recessions since 1950, according to the National Bureau of Economic Research. Hussman’s indicator gives a signal either before or during all eight. Even more impressively, there are no false signals.

However, it bothers me that the indicator ignores information on the magnitude of the underlying variables. One might reasonably expect the values of the change in credit spreads, yield curve slope, change in stock prices etc. to be relevant to the assessment of the probability of a recession.

To investigate this, I estimated a statistical model for assessing whether the economy is currently in a recession using the values of the Hussman variables. I included current and six-month-ago values to allow for lags in the relationship. The fitted probability estimates of the model are shown in the chart below. Historical performance is similar to the rule of thumb, with all eight recessions since 1950 signalled by the probability rising above 50% and no false signals. However, unlike the simple rule, the model has yet to flash red in the current cycle, with a latest reading of 20%.

I described my own recession probability indicators in an earlier post. The version including credit spreads has been rising recently but has also yet to breach 50% (current reading 45%).

Downside economic risks have clearly increased with further weakness in credit markets and rises in energy costs but I still think a recession can be avoided.