If This Is A Recession I Will Run Down The Street Naked*

The asterisk is because obviously there will be a recession one day the trick is to have an idea of when it could start. For me to run down the street naked, something I haven’t done since high school, a recession has to start in the next six months.

Why all the confidence? Well aside from all these pundits coming out saying there is a 100% chance that we are in a recession or that a recession will start before summer the reason is that the data doesn’t show it. You can make up indicators that don’t really make sense either in their construction or their interpretations or you can focus on one relatively narrow segment of the economy but none of that actually means we are entering a recession.

If you want to gauge the probability of a recession it might be helpful to really study the business cycle and how we enter and exit recession as well as how we do not. You then want to build a battery of models to help you interpret what is happening and what is likely to happen going forward. If you do this, and don’t focus on just one indicator, you will be far better off than what most pundits do.

One thing to look at, and maybe the most studied indicator in the history of economic indicators, is the yield spread. You can use just about any of the common spreads like the 10-2, 10-Fed Funds, 30-Fed Funds, 20-Fed Funds, etc. Anything that is definitely towards the long end of the curve and the short end of the curve should do. By the way you can do all of this in Excel using the excellent FRED plugin from the St Louis Federal Reserve.

What does the yield spread tell us? Well in general terms it is a tool that helps us gauge how tight or loose liquidity is. If the Fed wants loose monetary conditions they usually lower the Fed Funds rate and if they want tighter conditions they usually raise the Fed Funds rate. You can see this clearly in the chart below of the 20-Year yield, the Fed Funds rate, and recessions.  When the Fed wants to slow the business cycle the red line moves higher as they raise rates and when they want to spur business on they lower Fed Funds and the red line drops. Look at where we are now.

20 Year Yield and Fed Funds Rate

20 Year Yield and Fed Funds Rate

If we look at the actual spread of these two yields it might help you see what we are pointing at. You take the 20-Year yield and subtract the Fed Funds yield to get the spread. When it is moving higher we are usually expanding and when it gets almost flat or even inverted we are usually close to a recession.  Right now the spread is narrowing but it is a long ways off from being flat let alone inverted.

Yield Spread

Yield Spread

So right now it should be obvious that the Fed, despite hiking rates back in December, is still allowing business to enjoy relatively loose monetary policy. Everything from the yield spread is saying that a recession is not very likely in the near term. Before we end this however lets look at what a probit model says about the position of the yield spread.

The chart below shows the odds of a recession based on a model from Jonathan Wright at the Fed. His paper “The Yield Curve and Predicting US Recessions” shows how he built this model and how it works. In the paper there are actually two models. Model 1 is decent but Model 2 has been more accurate. What is great is that you can use both of them and then try and figure out what the yield curve and the Fed really want. Model 1 currently is saying there is a 17.91% chance of a recession while Model 2 is saying that there is a 0.05% chance of a recession.  Even if we just take an average of the two we get down to a 8.98% chance of a recession which is a far cry from a 100% chance or even a 50% chance of a recession.

Yield Curve Probit Model

Yield Curve Probit Model

Now to be fair we use far more indicators and models than just the yield spread. But here is the thing…only manufacturing is giving any real signs of stress. Every other major group of indicators is showing neutral to positive readings. Check out housing, employment, or even wages and you will see that things are actually looking pretty good.

Go immerse yourself in the data and see for yourself. In the meantime I am betting on me NOT having to run down the street naked.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *