BAML PRESENTS: The two most reliable indicators of recession

Economists have long sought to find the magical indicators that foretell an economic recession.

Nowadays, it’s pretty easy to crunch a bunch of data on a computer to see which data points might be the most useful.

And having dug through the numbers, Bank of America Merrill Lynch’s global economist Ethan S. Harris argues that there are two indicators that stand above the rest:

“Perhaps the most reliable indicator is the yield curve; in particular, the spread between three-month and 10-year treasuries. A second popular indicator is a broad index of equity prices; in particular, the six-month per cent change in the S&P 500 seems to work well,” he wrote in a recent note to clients.

As for why these two indicators are the “clear front runners,” Harris argues:

“Both capture forward-looking expectations for investors. The yield curve is a gauge of the expected path of interest rates. An inverted curve is usually a sign the Fed is being unusually tight, risking a recession in the months ahead. Broad stock prices capture expectations for earnings and equity risk premia and hence are closely correlated with expectations for economic growth and uncertainty about growth. Note both of these indicators relate to the broad economy, while a lot of recession indicators focus on specific sectors, such as housing starts or factory orders.”

Going one step further, the BAML analysts used data starting from 1959 to check these two ostensibly reliable indicators to see how they did in the past, which you can see in the charts below.

The chart on the left shows the results for the yield curve, while the one on the right shows the results for the S&P 500.

“It is clear why economists tend to favour the yield curve over stocks as a recession indicator,” Harris writes, looking at these two charts.

“The yield curve has singled a high risk of recession before every recession since 1959, but has had one significant false alarm: the aborted Fed tightening of 1967 signalled a high risk of recession,” he points out. But “the stock market sends a lot of false signals — there are 11 signals for the last six recessions.”

For what it’s worth, today, the yield curve model sees just under a 20% chance of recession in the year ahead, while the S&P is signalling about a 50% chance of recession.

In any case, even though these are the two “most reliable” indicators according to BAML analysts, it would be foolish to only look at these two indicators if for no other reason that that both could be distorted by other things happening in the economy. (For example, the recent shocks might have affected the stock market more than the overall economy given that mining companies and their suppliers make up a big part of the stock market, but not so much of the rest of the economy, points out Harris.)

“With the proper caveats, these models help inform our view of recession risks, but ultimately assessing the risk involves a judgment based on history, models and views of driving factors in the economy,” notes Harris.

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