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US yields rose throughout much of H1. This trend has largely continued in 3M yields, but not so much in US 2Y and 10Y yields. Starting at a 3.5% peak in mid-June, 2Y yields have since retreated 56bps while 10Y yields have fallen 82bps. This has left the curve to flatten, with 2s10s inverting in early July. Turning to the past week, 2Y (-11bps WoW) and 10Y yields (-14bps WoW) have continued lower while 3M yields saw a near-term reversal of the recent rise (-21bps WoW). This is partly because the market thinks the Fed will give up on reaching its inflation target to avert a recession. We disagree. In fact, Dominique expects the Fed to hike another 175bps by end-2022.
Consequently, our recession model, which uses the 2Y10Y part of the yield curve, assigns a 70% chance of a recession within the next twelve months (Charts 1 and 3). Meanwhile, the Fed’s recession model, which uses the 3M10Y part of the yield curve, jumped to a 20% chance of recession (Chart 2).
Background to Models
We introduced two models for predicting US recessions using the slope of the US yield curve. When long-term yields start to fall towards or below short-term yields, the curve flattens or inverts. This has often predicted a recession in subsequent months. Our model is based on the 2s10s curve compared to a model from the Fed that is based on 3M10Y curve. We believe that the 2Y better captures expectations for Fed hikes in coming years and is therefore more forward-looking.