As discussed in earlier posts, the preferred version of my US recession probability indicator (i.e. incorporating credit spreads) rose sharply in 2007 but peaked just short of the 50% “trigger” level. It suggested the economy would be very weak in late 2007 and early 2008 but would skirt an official recession, as determined well after the event by the National Bureau of Economic Research (NBER).

Amid widespread gloom, it may seem perverse to claim a recession is still not a done deal. However, available evidence suggests next week’s first-quarter GDP report will show modest growth, of perhaps 1% annualised, with gains in net exports and stockbuilding offsetting a further slump in housebuilding and flat consumption and business investment.

Aggregate hours worked by private non-farm employees declined at a 1.2% annualised pace in the first quarter. Allowing for trend productivity growth of 2%-2.5% pa, this also looks consistent with a small rise in output.

The consensus expects GDP to contract in the second quarter but timely coincident indicators have yet to suggest a further loss of momentum. New jobless claims have stabilised since late March, with only one recent week exceeding the 400,000 level suggestive of recession. As noted by Trim Tabs, withheld employment tax receipts also imply labour market resilience – see first chart below.

Recent further energy price gains will squeeze budgets but households are due to receive tax relief of over $100 billion – 1% of annual disposable income – starting next month. Investment will be supported by $50 billion of incentives for firms to purchase equipment in 2008.

Markets appear to be a little less certain of recession. Intrade’s contract allowing bets on the probability of two consecutive negative GDP quarters in 2008 has recently fallen back from a peak of 79%. (Two negative quarters is arguably a tougher requirement than an official recession – the NBER bases its determination on a range of indicators, not just quarterly GDP.)

For investors, whether the economy is in recession currently is less important than its position in six months’ time. The second chart updates the recession probability indicator, which is giving an “all-clear” signal for late 2008, based on recent falls in real interest rates and a steeper yield curve, which are judged to outweigh tighter credit conditions. (I have made some minor changes to the indicator to improve its historical performance. The new version would have predicted the eight recessions since 1955 with no false signals. Its recent peak remains just below the 50% “trigger” level.)

Simple models may well prove fallible in current unusual times but I continue to expect the US economy to perform better than many fear in 2008, with greater risk of disappointment in Europe. 2009 may be another story, however.

The fees payable under the Bank of England’s special liquidity scheme (SLS) imply the facility will be attractive only to banks currently either unable to borrow longer-term funds at LIBOR or unable to do so in sufficient size. The reported high take-up under the scheme – an initial £50 billion, expected to rise significantly further – is therefore surprising.

One explanation, as mentioned earlier, is that larger, unstressed banks have agreed to participate so that weaker institutions are not stigmatised for using the scheme. Banks may also be hoping that a high take-up will boost perceptions that the scheme represents a solution to the liquidity crisis and so help to restore confidence in the banking system, contributing to a fall in risk premia.

An alternative, more worrying possibility is that the problem of banks being unable to access the interbank market on reasonable terms is more widespread than previously thought. This would support claims that LIBOR seriously understates the true cost of funds for most institutions.

In this latter case, the SLS could be of significant benefit in reducing funding costs down to the quoted level of LIBOR. However, it remains unclear why it should result in a significant fall in the LIBOR-Bank rate spread.

For mortgage borrowers seeking to refinance fixed-rate loans, any helpful impact of the SLS may be outweighed by a recent sharp rise in short gilt yields and interbank swap rates, mainly due to international factors. As the chart shows, the two-year swap rate – a key influence on short-term fixed-rate mortgage pricing – has climbed 40 basis points since the April MPC meeting, reaching a four-month high.

My MPC-ometer suggested a 6-3 vote for a quarter-point rate cut in April, in line with the Sunday Times Shadow MPC. Today’s minutes reveal a 6-2-1 split, with Tim Besley and Andrew Sentance voting for no change and David Blanchflower for a half-point move.

There has been only one previous occasion of a three-way split in a month when the MPC has changed interest rates – January 1999, when rates were again cut by a quarter-point. Three-way splits also occurred in May and August 1998 and May 2006; rates were left unchanged in all three cases.

The minutes imply a further cut could be delayed until July or even later. Besley and Sentance will remain reluctant to ease aggressively until inflation expectations moderate – unlikely before late 2008. Within the majority group, some members voted for a reduction this month to keep policy consistent with the gradual easing path implied by the February Inflation Report projections. On this view, additional action may not be needed until August.

There are also hints of greater concern about exchange rate weakness, arguing for going slow on rate cuts. According to the minutes, a fall in the real exchange rate caused by an increase in the risk premium on sterling assets “would tend to boost net trade and warrant a more pronounced slowdown in domestic demand growth in the near term than otherwise”.

With inflation risks rising, the MPC is right to discourage hopes of rapid rate cuts but sharply weaker economic news or further financial woes could yet force the Committee's hand.

The equivalent yield on prime commercial property rose further to 5.9% in the first quarter and is now 110 basis points above its recent trough, according to CB Richard Ellis. The yield remains below its average of 6.4% over 1972-2007 but this may be a poor guide to “fair value”, for two reasons.

First, rents fluctuate significantly with the economic cycle. A high yield may not indicate that property is cheap if rents have been boosted above a sustainable level by a buoyant economy. Conversely, it may be right to invest when yields are low if rents are below trend and likely to benefit from future strong economic growth.

Secondly, any judgement about valuation must take account of returns on competing assets. The rental yield is often compared with yields on conventional gilts but this is invalid because bond interest is fixed while rents rise with inflation over the long run. In other words, the rental yield should be compared with real not nominal interest rates.

The chart shows a measure of valuation that incorporates these considerations – the gap between the normalised or cyclically-adjusted rental yield and real yields on long-term index-linked gilts. The normalised yield is currently lower than the actual yield (5.6% versus 5.9%) because rents are estimated to be 4% above trend, reflecting the economy’s recent strength. (There were much greater deviations in the early 1970s and late 1980s, when rents overshot by 30-40%.)

A below-average normalised yield is, however, counterbalanced by the low level of yields on long-term index-linked gilts. The gap between the two has surged from 3.1% in last year’s second quarter to 4.7% currently – the highest since 2004 and well above a long-term average of 3.6%.

Tight credit conditions and a slowing economy will restrain demand for property space but current valuations already discount much gloom. Property should outperform government bonds over the medium term.

The Bank of England’s new “special liquidity scheme” may prove ineffective because of its unattractive fee structure.

The scheme appears to be in the spirit of the term auctions of three-month funds last autumn . These attracted no bidders because the Bank set the minimum bid rate at a penal level.

The fee payable on a swap of mortgage-backed securities for Treasury bills will be the spread between three-month LIBOR and the three-month gilt repo rate – currently about 100 basis points. A floor has been set at 20 basis points but is irrelevant. Banks will use Treasury bills to obtain funds in the market at the gilt repo rate. Their total cost of funding – including the fee – will therefore equal LIBOR.

The scheme will help any institutions currently unable to access interbank funds at LIBOR but seems unlikely to result in a significant reduction in the current wide LIBOR-Bank rate spread. There is a danger that use of the scheme will be interpreted as an admission of weakness. The major banks may have agreed to participate in the scheme regardless of their need for funds to mute this signalling effect.

The scheme differs significantly from the Federal Reserve’s term securities lending facility, in which fees are set in an auction subject to a minimum for AAA-rated asset-backed securities of 25 basis points. Details of the latest auction show that some participants paid the minimum fee, implying the swap will have allowed them to obtain funds in the market significantly below LIBOR. The Bank of England appears to have rejected a comparable fee structure because of “moral hazard” concerns.

The relatively restrictive nature of the scheme suggests the LIBOR-Bank rate spread will remain elevated and the onus will be on the Bank’s Monetary Policy Committee to bring market rates down via further cuts in its Bank rate .