Recession Probability Remains High Despite Inflation Optimism

US treasury yields fell last week as investors weighed soft inflation data. June CPI surprised to the downside but added little to deflation trends. Headline inflation at +3% YoY reflects base effects and a 17% YoY decline in energy prices (median price YoY CPI remained above 6.4%.). And while core goods prices were flat for the third month in a row, structural changes underway in the US and globally suggest this is unlikely to last. Therefore, and despite the market’s optimism on inflation, we continue to expect the Federal Reserve (Fed) to hike twice more this year (July and November).

Turning to market moves, US 10Y yields closed the week at 3.83% (-23bps WoW, +10bps MoM) while the yield on the policy-sensitive US 2Y closed the week at 4.74% (-20bps WoW, +19bps MoM). In terms of yield curve inversion, the magnitude of the 2s10s inversion sat at -91bps 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, closed the week at 92% (Chart 1). 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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