Recession Probability Stays High as Investors Weigh Additional Rate Hikes

Federal Reserve (Fed) officials signalled that further interest rate hikes lie ahead, sending US treasury yields higher, last week. San Francisco Fed President Mary Daly said that two more rate hikes this year is a ‘very reasonable projection’ in an interview with Reuters. Additionally, Fed Chair Jerome Powell stated that the Fed is ‘likely within a couple of rate hikes of the level we need to be’ and that the Fed does ‘not see rate cuts any time soon’. In short, the Fed has not reached the end of its tightening cycle yet.

Turning to market moves, US 10Y yields closed the week at 3.74% (+2bps WoW, +2bps MoM) while the yield on the policy-sensitive US 2Y closed the week at 4.71% (+9bps WoW, +42bps MoM). In terms of yield curve inversion, the magnitude of the 2s10s inversion sat at -97bps 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 93%. It is also worth noting that the probability did not drop below 93% throughout the week. 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.

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