Do We Need to Wait for a Yield Curve Inversion to Predict a Recession? No.

“Others have seen what is and asked why. I have seen what could be and asked why not.” – Pablo PicassoHeading 3

Be Mindful of Elevated Recession Risks in 2018-2019

Predicting recessions is one of the most important elements of decision-making in the public and private sector. As such, a different set of policy tools is needed during a recession than that used for an economic expansion. The yield curve (spread between the 10-year Treasury and federal funds rate, for example), in particular the inversion point of the yield curve, is thought to be a very good predictor of a recession. An inverted yield curve has led all recessions since the 1969-70
recession.1 Furthermore, the Federal Open Market Committee (FOMC) has raised the federal funds target rate (fed funds rate) twice in 2017, which has brought the inverted yield curve topic (and the impending risk of a near-term recession) back into the spotlight. Other analysts are raising questions surrounding the yield curve’s effectiveness in predicting recessions. Presently, the fed funds rate is “recovering” from a historical low level (zero-lower bound) and, as such, the yield curve may not invert in this cycle as it has in the past. That is, the yield curve stayed in the positive territory (did not invert) during the 1954-1965 period and that era experienced two recessions (1957-1958 and 1960-1961 recessions).2 In this report, we propose a new framework that identifies a threshold between the fed funds rate and the 10-year Treasury yield (we call it FFR/10-year threshold). In a rising fed funds rate environment, the threshold is breached when the fed funds rate touches/crosses the lowest level of the 10-year Treasury yield in that cycle. When this occurs, the risk of a recession in the near future is significant. Our framework has successfully predicted all recessions since 1955 with an average lead time of 17 months. Furthermore, our framework predicted several recessions before the yield curve inversion point and, therefore, serves as a more effective tool in predicting recessions. That is, with our framework, we do not need to wait for the yield curve to invert to predict a recession.
Why is our analysis important for decision-makers? In the current monetary cycle, the lowest 10-year Treasury yield was 1.36 percent (hit on July 5, 2016) and the current fed funds rate is 1.25 percent. We are forecasting one more rate hike by the FOMC (December 2017), and, if we are correct, the fed funds rate will be 1.50 percent, thereby surpassing the lowest level of the 10-year Treasury (1.36 percent) and thus breaching the threshold. Historically, when the threshold is met, there is 69.2 percent chance (average probability) of a recession within the next 17 months 

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