The US yield curve is warning about a looming recession but many other indicators aren't

Gary Hershorn/Getty ImagesA light at the end of the inverted yield curve. Maybe.
  • The US yield curve has now inverted with three-month yields now sitting above 10-year yields for the first time since 2007.
  • Every time this has happened in the past 50 years a US recession has soon followed.
  • Westpac Bank says when assessing recession risks, other indicators that have a good track record for predicting downturns should also be considered.
  • Using not only the yield curve but also the performance of stocks, the US ISM PMI and credit spreads, it’s broader model of recession risks puts the currently probability of a downturn in the next year at just 5%.

The US yield curve has now inverted with three-month yields now sitting above 10-year yields for the first time since 2007.

Every time that’s occurred over the past 50 years a US recession has soon followed. It’s little wonder why recent developments have triggered renewed debate as to whether the curve inversion means the next recession is imminent.

However, despite such a good track record as a predictor of economic downturns, there’s no shortage of analysts out there who believe this time may be different.

Richard Franulovich, Westpac bank’s New York-based Head of FX Strategy, is among that group.

He’s not convinced the current signals from the curve have started the countdown clock for the next recession, pointing out in a note released on Wednesday that other recession indicators suggest the risk of a downturn in the short to medium-term look negligible at this point.

“The yield curve is still only part of the story,” Ranulovich said.

“A well specified model should include an ensemble of known recession predictors.

“Equities, credit spreads and soft data such as the ISM survey for example all contain useful forward looking information about growth prospects. We find that a broader recession probability model that incorporates these inputs points to very negligible recession risk.”

Usefully, Franulovich has created such a model.

“We estimate a model over 1970-1996 in-sample, using only statistically significant and correctly signed lagged values of the US three-month-10-year curve, the 12-month change in US stocks, the level of US Baa credit spreads and the ISM index,” he said.

And here’s what the model spits out as the current implied likelihood of a US recession based on those inputs: 5% within the next 12 months.

Westpac Bank

“While the yield curve is the single most important input with the highest coefficient, the explanatory power of stocks is relatively high too and stock market momentum remains much stronger than what is typically seen into recessions.

“The same applies for both the ISM index and credit spreads — the ISM is admittedly down from cycle peaks while credit spreads have widened from their cycle lows but neither are at levels that scream recession risk.”

As for what could see the risk of a recession lift sharply, Franulovich said it would lift to 60% within 12 months should the curve inversion last at least three months, the ISM PMI drop below 50, US stocks decline in year-on-year terms for several months with the yield spread of Baa debt blowing out to over 300 basis points over risk-free rates, up from 234 basis points at present.

Importantly, he said all of these would have to occur simultaneously, not individually, to get the implied recession risk to this level.

In a nutshell, while the signals from the curve should not be ignored, recession risks should be evaluated by more than just the yield curve.

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