Goldman: Curve Inversion Likely, Recession Risk Signal Comes W/ Caveats

Goldman Sachs note that “the rapid early cycle flattening of the yield curve has fuelled worries about what the rates market may be signaling about recession risk. Our revised forecasts discussed have the 2s10s U.S.Tsy curve inverting around mid-year and staying inverted as the Fed continues to tighten policy. However, with inflation elevated and the breakeven curve substantially downward sloping, the backdrop for the nominal curve shape differs from recent cycles and is more comparable to the dynamics seen in the 1970s and 1980s, when curves tended to be flatter on average and invert more significantly ahead of recessions. Using our backcast history of real yields and breakevens, we find evidence that in higher inflation regimes, the impact of flattening on recession probabilities is higher if driven by the real curve as opposed to the inflation curve. In particular, a probit model estimated over a high inflation environment using the real and inflation curve split (rather than simply the nominal curve) implies a ~15% probability of transitioning into recession over the next 12 months (compared to the roughly 25% probability that the nominal curve alone suggests). On balance this suggests that while an inverted curve is suggestive of an increase in recession odds, so long as the inflation curve remains significantly inverted, the degree of inversion consistent with a given recession probability is likely greater this cycle than in recent ones.”