Recession Probability Remains Elevated After Fed Comments

Last week saw mixed messages from Federal Reserve (Fed) officials. Market pricing of a June hike increased throughout last week, largely based on Fed speeches. On Thursday, Dallas Fed President Lorie Logan said ‘the data in coming weeks could yet show that it is appropriate to skip a meeting. As of today, though, we aren’t there yet.’ Friday saw New York Fed President John Williams underline that ‘there is no evidence that the era of very low natural rates of interest has ended.’ Meanwhile, Fed Chair Jerome Powell explained that the Fed was already in restrictive territory and that therefore its decision would be driven by short-term data developments.

A June hike is justified on economic grounds. The labour market remains very tight, and inflation is well above target – based on data alone we would expect the Fed to hike 25bps. However, the growing risk of a debt-ceiling crisis could preclude it.

Turning to market moves, US 10Y yields closed the week at 3.70% (+24bps WoW, +10bps MoM) while the yield on the policy-sensitive US 2Y closed the week at 4.28% (+30bps WoW, +4bps MoM). In terms of yield curve inversion, the magnitude of the 2s10s inversion sat at -58bps on Friday. The probability of recession increases with yield curve inversion.

The probability of recession within the next twelve months assigned by our recession model, which uses the 2Y10Y part of the yield curve, oscillated between 80% and 84% throughout last week, before closing the week at 84% Friday. Meanwhile, the Fed’s recession model, which uses the 3M10Y part of the yield curve, produced a 67% 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.

Dalvir Mandara is a Quantitative Researcher at Macro Hive. Dalvir has a BSc Mathematics and Computer Science and an MSc Mathematical Finance both from the University of Birmingham. His areas of interest are in the applications of machine learning, deep learning and alternative data for predictive modelling of financial markets.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Photo Credit: depositphotos.com

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