US recession in 2016: high or low probability?

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.

Fred adjusted pic.JPG

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)  

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