MNI INTERVIEW: US Recession Odds Now 1-In-3, Yield Curve Shows

By Jean Yung

     WASHINGTON (MNI) - A recent yield inversion curve signals a one-in-three

probability of a recession a year from now, compared to just 4% at the start of

2018, Federal Reserve Bank of Cleveland economist Joe Haubrich said in an

interview.

     These odds, computed using data on the spread between 3-month bills and

10-year notes going back to 1960, have been "reasonably accurate," though there

is no specific threshold beyond which a recession is assured, Haubrich said.

     The 10-year-versus-3-month spread turned negative for the first time since

2007 on March 22, hitting a low of -11.3 basis points Thursday before returning

to positive territory, triggering downturn speculation. The last time the curve

inverted, the Great Recession followed 14 months later.

     The Cleveland Fed model's recession probabilities hit a high of around 47%

in late 2007, shortly before the Great Recession. Further back, the odds

registered at nearly 90% at the height of the 1980s recession, suggesting it

would continue for a while. Using a different spread, such as the 10-year yield

minus the 2-year, which recently fell to a 12-year low but has yet to invert,

would still give similar results.

     "If you're trying to decide where the economy is going, you'd want to take

into account a decent probability of a recession," and the bigger the inversion

and the longer it lasts, the higher that probability will go, Haubrich said.

"But this model is not set up for making a call. I'm leaving it in the eye of

the beholder to take that information and do what they want with it."

     --RECESSION PREDICTOR

     The yield curve's predictive powers have a long, successful history that

predates even the creation of the Federal Reserve, though it is unclear exactly

why it works, Haubrich said.

     Intuitively, the Fed's interest rate hikes raise borrowing costs at the

short end but also have the potential to "squeeze some inflation out of the

economy" which can drag down longer-term interest rates, Haubrich said. A

sufficiently aggressive tightening could cause an inversion that might be

followed by a recession in the future, he said.

     Analysts have come up with several interpretations of the most recent

inversion, including that fixed income markets expect rate cuts due to either an

impending recession or as the Fed tries to boost inflation. Yet another

interpretation, offered by JP Morgan, is "markets do not expect rate cuts at

all, but are now compensating investors for taking short-run interest rate risk

with a negative term premium."

     Haubrich is circumspect in his analysis. "We don't really know for sure why

the yield curve is a good predictor for future output and future recessions," he

said, but "there's a long history of when it has worked."

     --LESS ACCURATE

     That said, Haubrich acknowledges that the yield curve may have become

somewhat less reliable in recent years.

     Some periods where the curve has been flat have not presaged recession,

while the Fed's strong inflation-fighting credibility means tighter spreads are

more normal than in the past.

     Term premia have also fallen to levels that are very low by historical

standards, with some research suggesting they are close to zero across the yield

curve, meaning additional modest tightening by the Fed could lead to an

inversion. By contrast, the 10-year term premium was close to 100 basis points

when the spread between the 3-month and 10-year Treasury yields was at its peak

of 325 basis points in early 2010.

     "I don't want to discount those views, if term premia are different now or

for other reasons," Haubrich said. But, "we have an indicator that has worked

well."

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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