Monetary Policy & Inflation | US
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US treasury yields closed the week lower after Federal Reserve (Fed) Chair Jerome Powell’s much-awaited pre-FOMC speech. He announced that a move to 50bp hikes ‘may come as early as the December meeting’ and an increase in the terminal federal funds rate (FFR) projection in the December SEP. However, Friday’s jobs data was at odds with the dovish comments. US non-farm payrolls (NFP) increased by 263,000 in November against an expected 200,000. The hot jobs data is in line with Dominique’s view that continued NFPs of well over 100,000 are likely to lead to further increases in the Fed’s estimate of the terminal fed funds rate (FFR).
Turning to market moves, US 10Y yields closed the week at 3.51% (-17bps WoW) compared to 4.28% (-14bps WoW) for the 2Y and 4.22% (flat WoW) for the 3M. Despite yields tracking lower on Friday, short-term yields continued to outpace longer-term yields with the 2s10s inversion deepening to -77bps. The 3M10Y part of the yield curve inverted on 10 November and the slope is currently -71bps. 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). This is a four-decade high. 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 47% 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.