US recession: rising risks don’t mean a contraction is imminent

Thought of the day

by Chief Investment Office 07 Feb 2019

On some measures the risks of a US recession are rising. The New York Federal Reserve’s recession probability indicator, which uses the spread between three-month and 10-year Treasury yields to predict the chances the economy contracts in the next year, has hit 24% – the highest level since 2008.

But, while we think the US economy will slow this year compared with 2018, we don’t see a recession as imminent.

  • The New York Fed’s measure, while rising, is still well below the levels of 42% and 46%, reached at the time of the 2008 and 2001 recessions, respectively.
  • Yield curve inversions are often considered a precursor to a recession. Both the 3m/10y and 2y/10y yield curves have inverted prior to each of the last seven US recessions going back to 1970. But the 3s/10s hasn’t yet inverted; after reaching a low of 15 basis points in early January, the curve has widened back out to 25bps. The 2s/10s curve, which narrowed to 11bps in December, has also not yet inverted and is currently 16bps. Since 1970, even after inversions of the 3m/10y and 2y/10y curves, a recession hasn’t followed for an average of 23 and 21 months, respectively.
  • This time really could be different, making the yield curve a less accurate predictor. Specific factors such as institutional demand for long-term bonds and low inflation premia are helping hold down long-term rates, making flatter/inverted curves more likely as short-term rates rise. The term premium on 10-year US bonds, which is the excess yield that investors need to be prepared to hold long-term bonds instead of a series of shorter-term bonds, is currently –47bps compared with an average of +78bps since 1990.While the US economy is slowing, we don't think it will contract in the next 12 months and expect 2.4% growth this year and 2% next year. Looking at the statistics, the number one way a US yield curve inversion can hurt your portfolio is if it makes you reflexively sell stocks. History shows that, on average since 1960, after an inversion of the 2y/10y yield curve the S&P 500 returns 29% before it peaks.

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