The Fed uses a model forecasting the probability of US recession within the next 12 months. The model has had a high success rate in relation to past recessions – what is it telling us at the moment?
How it works: The Fed’s model looks at the spread between 10 year and 3 month treasury rates – this has been a strong predictor of previous recessions. While the 10 year and 3 month treasury rate spread is normally positive, a negative reading indicates a coming recession.
Is it an effective recession predictor? Short answer is yes. Before each of the last 7 recessions, short-term interest rates rose above the long-term rates. This is the opposite (inversion) of the normal yield curve. See the 10 year minus 3 month T-Bill spread below – the vertical grey shaded areas indicate US recessions. The spread was negative (i.e. blue line below the black line) in 2001 and 2007, in each case this preceded a recession in the following year.
What does the current reading tell us? The current 10 year minus 3 month spread is +1.75%. The reading is positive meaning a recession is unlikely in the next 12 months. In fact, the model puts the chances of recession at only 4% (i.e. extremely low probability).
What does this mean for markets? If a US recession is unlikely, why is the S&P500 facing such a relentless sell-down? Commentators explain this is because of concerns in China and the impact of low crude oil prices. We don’t buy into the “perma-bear” argument (that equity markets are now in a new long term downward trend). We believe current volatility is a market correction which (although brutal) is not exceptional. We remain positive on the outlook for global equities in 2016.
By Karl Geal-Otter and John Berry
(Sources: Deutsche Bank, FRED and New York Fed)