- The spread between US 2-year and 10-year bond yields – a key indicator of recessions – fell sharply to its lowest level in 11 years this week.
- Deutsche Bank says the risk of a recession is “very low” over the next 12 months, but rises significantly to 80% over a three-year time frame.
- However, the analysts said if and when a recession does occur, other indicators suggest it shouldn’t be a particularly steep one.
Some serious rumblings in the bond market at the start of this week have refocused attention back on the US yield curve.
Trade fears and concerns over the growth outlook saw yields on benchmark US 10-year bonds fall more than 10 basis points — an unusually sharp move — to 2.91%, just 11 basis points higher than US 2-year yields.
That’s the lowest gap since 2007, and markets keep a close eye on the US 2-10 spread (“the yield curve”) because every time it has inverted since 1955, a recession has followed.
Some inversions have already occurred — the spread between US 2-year and 5-year debt turned negative this week — which has increased speculation the 2-10 curve is soon to follow.
If it does, history says a recession is on the cards. But perhaps a more interesting question is — how long does it take after an inversion for the recession to actually occur?
For example, prior to the past five US recessions the S&P 500 kept rising for an average of 19 months following the first 2-10 inversion.
And Deutsche Bank’s latest modelling — based on some detailed yield curve metrics — indicates a similar time frame in the years ahead.
The risk of a US recession over the next 12 months is “very low, less than 5%”, Deutsche Bank said.
However, “there is 25% chance of a recession at some point over the next two years”. That’s near the highest probability level since the 2008 financial crisis.
And “over the next three years, there is nearly an 80% chance of a recession according to this model”.
Deutsche Bank’s model includes the 2-10 spread, along with two other yield differentials that have been highlighted by the US Fed as useful leading indicators:
- The yield spread between 3-month US treasuries and 10-year treasuries; and
- The spread on 3 month treasury futures (18 months in advance) and spot 3-month rates.
They then add in three more inputs: the Fed’s estimate of neutral interest rates (neither supportive or restrictive), the risk premium on corporate bonds, and the Chicago Fed’s measure of tightness in financial conditions.
Crunch that all together, and the figures suggest that recession risks remain relatively muted — for now:
The analysts added that should a recession occur, it may not be a particularly deep one. And that’s largely because the buildup of financial imbalances in the US economy hasn’t been as steep as previous years.
“Aggregate financial stability risks remain just below historical averages — a view shared by the Fed which recently updated its monitoring of financial stability conditions.”
They also pointed to three other reasons that suggest any pending US recession should be relatively benign:
- The emergence of US shale oil, which helps to reduce the effect of oil price spikes on the economy;
- The breakdown of the Phillips curve, which points to less upward pressure on wages (and by extension inflation) “thereby taking pressure oﬀ of the Fed to overtighten”; and
- As part of its current tightening cycle, the Federal Reserve is likely to be “a good deal more cautious than in the past”.
“In short, we agree that recession risks should rise more meaningfully beginning in 2020, but a recession is not part of our baseline expectation,” Deutsche Bank said.
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