As expected, the Federal Reserve (Fed) hiked 25bps at the policy meeting on Wednesday last week – yields mostly fell after the news.
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As expected, the Federal Reserve (Fed) hiked 25bps at the policy meeting on Wednesday last week – yields mostly fell after the news. However, following hotter-than-expected US NFP data on Friday (+517,000 versus +187,000 expected), and a sharp improvement in services PMI, markets have repriced up the federal funds rate (FFR) trajectory. Looking forward, several Fed speakers will give their reaction to the data throughout this week – chief of which will be Chair Powell on Tuesday.
Turning to market moves, US 10Y yields closed the week at 3.53% (+1bps WoW) compared to 4.30% (+11bps WoW) for the 2Y and 4.57% (flat WoW) for the 3M. Important parts of the yield curve remain deeply inverted. The magnitude of the 2s10s inversion deepened to -77bps on Friday from -69bps the day before. The inversion of the 3M10Y part of the yield curve sits at -104bps. 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). Meanwhile, the Fed recession model, which uses the 3M10Y part of the yield curve, produces a 56% chance of recession (Chart 2). Notably, both models are producing recession probabilities higher than that of the 2007-2008 Global Financial Crisis (GFC).
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.