Recession Update: Is the Yield Curve Still Effective?
|It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
– Mark Twain
Executive Summary
Recent inversions of the 2-year to 10-year Treasury yield curve have heightened markets’ recession anxieties and pushed many analysts to question whether the yield curve is still a reliable indicator of recession. In order to assess whether these events represent a material change in the probability of recession, we updated our models to estimate potential risks of a recession in the short-term (within the next six months) as well as in the medium-term (for the next couple of years). Most of our models suggest minimal short-term recession risk, with our preferred Probit model suggesting a low probability of a recession occurring within the next six months. The yield curve Probit model, on the other hand, offers a more pessimistic outlook. With a recession probability estimate of 32.7%, this model is at its highest level since the Great Recession, but still remains below levels seen prior to previous recessions (Figure 2). The yield curve would need to invert significantly and remain inverted for months before it would be a reliable recession signal.
Finally, our medium-term framework, which focuses on changes in the relationship between the fed funds rate and the 10-year Treasury rate, is also showing little sign for worry, following the Fed’s shift toward more accommodative policy. Our GDP forecast for this year as well as for 2020 is 2.3%, but there is plenty of uncertainty in the air. Ongoing trade tensions between China and the United States, rising risk of a no-deal Brexit and a slowing global economy cloud the economic outlook. We will continue to monitor the upcoming data for recession signals and will release an update, if we notice any significant change to our current recession outlook.
Our models suggest a low probability of recession in the short-term but uncertainty is in the air.
Forecasting Recession Risks for the Short-Term
Our preferred Probit model uses a handful of economic indicators, including the LEI, S&P 500 index and the Chicago PMI employment index, as predictors. The model predicted (in real-time) a 58% probability in Q3-2007. 1 Additionally, it did not indicate a recession during 2010-2012, allowing us to avoid joining the “double-dip” camp. Using data through July 2019, our preferred model suggests a meager 4.2% chance of a recession in the short-term (Figure 1). The key predictor of the model, the LEI, is still positive on average for 2019. While a negative turn in the LEI would increase the downside risk to our outlook, the positive momentum of the LEI over the past 12 months makes it difficult to imagine a recession during the next six months. In addition to our preferred Probit model, we built six different Probit models in 2016, using information from various sectors of the economy, in order to better capture the breadth of factors that can indicate a recession. 2 With an average of 20.0%, our Probit models suggest low risk of a recession in the short-term (Figure 4). Nevertheless, there is always the possibility of an unforeseen shock.
Given the positive momentum of the LEI it would be very difficult to imagine a recession during the next six months.
The Yield Curve Has Inverted, Now What? Recession?
For the first time since the Great Recession, the 2-year to 10-year yield curve has inverted, raising concerns of an upcoming recession, due to the fact that it inverted prior to the past seven recessions (Figure 3). Including data up to July 2019, the yield curve Probit model estimates a 32.7% probability of a recession, marking the highest estimate since the Great Recession. The current reading, however, still remains below the probabilities indicated prior to the past three recessions. This lower reading in the face of an inversion is likely the result of the limited duration of the inversion. Before each of the last three recessions, the yield curve inverted for at least six consecutive months. The most recent inversions, in contrast, have lasted for less than a day. Essentially, if the yield curve were to remain inverted for about six months the probability of a recession would likely be boosted to a historical high. For now the yield curve Probit model does not necessarily signal that a recession is around the corner.
The yield curve Probit model estimates a 32.7% probability of a recession, marking the highest estimate since the Great Recession.
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