Monetary Policy & Inflation | US

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Federal Reserve (Fed) speakers last week indicated that the central bank would continue hiking interest rates. Notably, Bullard (a hawk) indicated a minimum terminal FFR of around 5% with an upper bound at 7% (Dominique continues to expect a terminal FFR close to 8%). US treasury yields reacted accordingly with 10Y yields (3.82%, +6bps MoM), 2Y yields (4.51%, +36bps MoM) and 3M yields (4.15%, +82bps MoM) rising on Friday.

Short-term yields continue to outpace longer-term yields with the 2s10s inversion (-69bps) now at its deepest levels since the 1980s. We think it inverts to at least –100bps. The 3M10Y part of the yield curve inverted on 10 November and the slope is currently around -33bps.

Our recession model, which uses the 2Y10Y part of the yield curve, now assigns an 87% chance of a recession within the next twelve months (Charts 1 and 3). This is a four-decade high. It has signalled at least an 80% chance of recession consistently since the start of November. Meanwhile, the Fed’s recession model, which uses the 3M10Y part of the yield curve, produces a 36% chance of recession (Chart 2). The probability of recession increases with yield curve inversion.

## 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.