Recession Probability Remains High as Investors Anticipate Fed Rate Hike

US treasury yields increased last week with markets anticipating the Federal Reserve (Fed) to deliver another rate hike at this week’s FOMC meeting. Clarification of the Fed’s reaction function, given there will not be a Summary of Economic Projections (SEP), will likely be the most interesting development with Dominique looking for specifics on the Fed’s reaction to growth surprises, given that they have proven ambiguous before.

Turning to market moves, US 10Y yields closed the week at 3.84% (+1bps WoW, +10bps MoM) while the yield on the policy-sensitive US 2Y closed the week at 4.82% (+8bps WoW, +14bps MoM). In terms of yield curve inversion, the magnitude of the 2s10s inversion sat at -98bps on Friday. The probability of recession increases with yield curve inversion.

The probability of recession within the next twelve months, assigned by our recession model, which uses the 2Y10Y part of the yield curve, closed the week at 94% (Chart 1). Meanwhile, the Fed’s recession model, which uses the 3M10Y part of the yield curve, produced a 67% 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.

Dalvir Mandara is a Quantitative Researcher at Macro Hive. Dalvir has a BSc Mathematics and Computer Science and an MSc Mathematical Finance both from the University of Birmingham. His areas of interest are in the applications of machine learning, deep learning and alternative data for predictive modelling of financial markets.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)