Hotter Than Expected Inflation Sends Recession Probabilities Back to 80%

US Treasury yields rose on Friday after September CPI came in hotter-than-expected (8.2% vs. 8.1% expected). The release supports Dominique’s expectations for a 75bp hike at the November FOMC meeting. Additionally, hawkish September FOMC minutes appear to show a Fed pivot is not coming any time soon. According to the minutes, many participants noted that inflation is ‘showing little sign so far of abating’ and that they had ‘raised their assessment of the path of the federal funds rate that would likely be needed to achieve the Committees goals.’

Turning to market moves, 10Y yields hit 4% on Friday (+85bps MoM) while 2Y yields hit 4.48% (+103bps MoM). Consequently, the inversion of the 2s10s curve deepened to -48bps.

Our recession model, which uses the 2Y10Y part of the yield curve, now assigns an 80% chance of a recession within the next twelve months (Charts 1 and 3). It has been signalling at least a 70% chance of recession consistently since 13 September and hit 81% again on Thursday last week. Meanwhile, the Fed’s recession model, which uses the 3M10Y part of the yield curve, produces a 20% chance of recession (Chart 2). The probability of recession increases with yield curve inversion.

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. 

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.

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