The Yield Curve and US Recession Risk

We are living in one of the strangest periods in economic history and the definition of a recession has always been a little convoluted.

In some sense, you really only know you’re in a recession because you feel like you are, then 6 months later a group of economists get together and decide whether or not were.

The stock and bond markets have already priced in a recession, and that’s a great thing because as the chances of recession fall prices should rise.

The Estrella and Mishkin way of forecasting a recession, the one shown above, uses the treasury yield curve.

When the yield curve is highly inverted, it further enhances the chance of a coming recession. Right now the yield curve is inverted to levels not seen since the turn of the century. Which is why the recession probably going into 2024 (12 months ahead) is over 57%.

However, as I said earlier investors have been pricing in a recession for over a year now, waiting for the data to start reflecting it. And so far, we haven’t seen any signs of an overarching recession, besides in a few industries.

Goldman Sachs lowered their recession forecast from a 35% chance to a 25% chance, well below the median of 65%, according to the Wall Street Journal Forecaster Survey.

The long run average chance that the economy will enter a recession in any 12-month period is around 15%, and the main reason Goldman Sachs takes this view is because the rebalancing of the labor market is incomplete.

Because we are presumably entering the top of the Federal Reserve hiking cycle and labor markets have not shown substantial pain the chances of a US recession are falling.

But 5.25% rates are too restrictive for our modern economy. The longer they are held at that level the higher the chances of a recession in the coming years.

Because of this and because of the many other recession forecast cuts the markets have responded by showing a ~7% gain on the S&P 500 and a ~13% gain on the Nasdaq Composite.