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The Federal Reserve (Fed) hiked rates by 75bp last week, as we expected. US Treasury yields reacted accordingly – the yield on the US 10Y rose to 4.14% (+47bp MoM) on Thursday while US 2y yields hit 4.71% (+55bp MoM), their highest level since 2007 – as markets absorbed the hawkish Chair Powell presser. Consequently, the 2s10s inversion (-57bp) hit four-decade lows.
The October jobs data strengthened Dominique’s case for a 75bp hike in December. The October nonfarm payroll printed higher than markets had expected. It adds to existing employment data that suggests the labour market is tight.
Our recession model, which uses the 2Y10Y part of the yield curve, now assigns an 81% chance of a recession within the next twelve months (Charts 1 and 3). It hit four-decade highs (84%) on Thursday (3 November) and has signalled at least a 70% chance of recession consistently since 13 September. Meanwhile, the Fed’s recession model, which uses the 3M10Y part of the yield curve, produces a 24% 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.