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US treasury yields closed the week higher after November’s PPI (up 0.3% for the month) showed an increase in wholesale prices. This supports expectations of further rate hikes from the Federal Reserve (Fed), who are expected to rase interest rates by 50bps at this week’s December FOMC meeting, in line with Dominique’s expectations. Despite markets pricing a 50bp hike of the federal funds rate (FFR) this week, we maintain that they are underestimating the terminal FFR and have unrealistic expectations of rate cuts in 2023. Dominique expects a 2023 dot in the 5.25 to 5.5% range.
Turning to market moves, US 10Y yields closed the week at 3.57% (+6bps WoW) compared to 4.33% (+5bps WoW) for the 2Y and 4.19% (-3bps WoW) for the 3M. The 2s10s inversion deepened to lows of -84bps on Wednesday before finishing the week at -76bps. Consequently, the probability of recession hit highs of 91% on Wednesday. The 3M10Y part of the yield curve inverted on 10 November and the slope is currently -62bps. The probability of recession increases with yield curve inversion.
Our recession model, which uses the 2Y10Y part of the yield curve, assigns an 89% chance of a recession within the next twelve months (Charts 1 and 3). It has signalled at least an 80% chance of recession consistently since the start of November. Meanwhile, the Federal Reserve’s (Fed) recession model, which uses the 3M10Y part of the yield curve, produces a 44% 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.
Chart 1: Macro Hive Recession Model Based on US 2Y10Y Curve
Chart 2: Fed Recession Model Based on US 3M10Y Curve
Chart 3: Macro Hive Recession Model Historical Probabilities