The New York Federal Reserve’s probability model, which the Fed uses to predict the probability of a recession in the United States in the next 12 months, hit a reading not seen since 2009 this past June.
The reading, 32.9 percent, might not seem that high at first. However, every recession since 1960 has been preceded by the model breaching the 30 percent threshold.
Feel like the measure probably has a way to go before things get serious? Think again. The most recent recession never weighed in anywhere near what most people believe is a sure thing: 100 percent.
“In front of the Great Recession (2008), the probability never got above 40 percent,” observed Fundstrat analyst Thomas Lee in a recent note to clients.
Readers should be aware, however, that Lee is something of a skeptic when it comes to the probability model. “The probability could rise to 100 percent and it could take another two years [before a recession],” he added.
The Model is Consistent with Other Indicators
If, as is the case with Lee, one potentially problematic indicator is not enough for you, then do not be too hasty when it comes to writing off the New York Fed’s model and its relatively negative outlook.
The yield curve between 10- and 3-month Treasury bonds also recently became inverted, a classic sign of a pending recession.
The inversion occurred in March of this year and again in May. Morgan Stanley Wealth Management analyst Lisa Shalett compared the inversions to a “warning shot now being fired” in terms of a looming recession.
She noted the longer an inversion continues, the more likely it is to precede a recession. A month or longer is particularly problematic, although most analysts say alarm bells should not really start ringing until the inversion extends for multiple months.
Either way, however, 2019’s repeated inversion incidents are making many investors nervous and sending them into safe-haven investments like gold.
Predictions from the U.S. Bureau of Labor Statistics that the U.S. gross domestic product (GDP) will likely come in at an annual rate of 2 percent (vs. 3 percent in 2018) are also putting many investors on alert.
How the New York Fed’s Indicator Works
The New York Fed uses treasury spreads to predict recession, just as do most analysts who focus narrowly on the yield curve. The model is simply another method of comparison, where the difference between the 10-year and the 3-month Treasury rates are measured directly. When the measure is negative, the odds of a recession rise.
Critics of the measure say it focuses too narrowly on Treasury rates and excludes other, currently positive factors like employment. Advocates for the measure say the narrow focus makes the measure more reliable and less susceptible to “spin” from adjusted numbers or consumer sentiment.
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