Recession Still 78% Likely Despite Negative Surprise to US CPI

Short-term and long-term US yields are moving in tandem: last week the US 2Y-10Y spread remains at -41bps after both US 2Y and 10Y yields rose 10bps over the past week. It means they are closer to their mid-June highs. Meanwhile, money markets are continuing their climb, 3M yields rose 15bps over the past week.

However, the week-on-week moves disguise what was a volatile week for US yields; the two-year popped 20bps lower following the US CPI print. However, Dominique believes the negative surprise is just a transitory respite for the Federal Reserve. Her expectations remain unchanged: a 75bps hike at the September FOMC meeting and total hikes of 175bps by year-end. This is because core inflation remains strong; the dip was almost entirely energy-related. Furthermore, it means there is still room for more weakness in the US short-end, and therefore, room for further curve inversion.

On recession probabilities, our model, which uses the 2s10s part of the yield curve, continues to assign a 78% chance of a recession within the next twelve months (Charts 1 and 3). Meanwhile, the Fed’s recession model, which uses the 3M10Y part of the yield curve, remains close to 20% (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 the 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. 

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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