RaboResearch - Economic Research

The next US recession

Economic Comment

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  • The US treasury yield curve is getting flatter and has already inverted at the 2-5 segment. The 2-10 spread has fallen to 14 bps, about half of what it was a month ago
  • Our recession model now indicates a 47% probability of a recession by April 2020
  • Since the FOMC thinks that inverting the yield curve does not cause a recession because ‘this time is different’, we expect the 2-10 segment of the yield curve to invert in 2019Q2, which would signal a recession in 2020Q4

Introduction

Three years ago we wrote the report Thinking about the next US recession. At that time the economic expansion after the Great Recession had lasted for 75 months (as of 2015Q3). With the average post-WWII expansion lasting 58.4 months it could be argued that the next recession was long overdue. Yet at present, we are even close to a record expansion. If the economy continues to grow, by mid-2019 the longest expansion –which lasted 120 months between 1991 and 2001– will be matched.

However, recessions do not occur because of the passing of time, but because the economy is dealing with a shock of some sort. What kind of shocks are usually seen as the causes of recessions? Three years ago, we distinguished between various types of shocks. The US economy could be hit from abroad by an external demand shock or an oil shock. At home, fiscal and monetary policy shocks could derail the recovery. The most severe recessions are usually associated with a financial crisis. While external demand shocks and oil shocks could cause substantial headwinds for the US economy, a recession would most likely be caused by domestic policy mistakes or bubbles. Fiscal policy errors could lie in abrupt cuts in government spending or a game of chicken on the debt ceiling that goes wrong and leads to a government default or a sovereign debt crisis. The normalisation of monetary policy from extremely low policy rates and excessive central bank balances could also pose a threat to the economic recovery if the Fed moves too fast, in particular if a bubble gets popped along the way.

Figure 1: Probability of a recession at 17 month horizon
Figure 1: Probability of a recession at 17 month horizonSource: Rabobank

Two years ago, in the report Is the next recession visible in the yield curve? we developed an econometric model that could provide an early warning signal of the next recession, based on the shape of the yield curve. In the past, US recessions were preceded by an inversion of the yield curve. At present, the probability of a recession at the 17 month horizon (= April 2020) is 47%, according to our model.[1] So it seems that 2020 is going to be a challenging year. Therefore, we would like to look beyond the horizon of our model.

Footnote
[1] Our model is based on the 12m-10y spread and includes a correction for the historically low levels of short-term rates which make an inversion more difficult than in the past.

Will the Fed make another monetary policy mistake?

This year’s statements by FOMC participants –most notably Chairman Powell– that they do not think that a yield curve inversion would signal a recession because ‘this time is different’ allow us to look further into the future. The Fed’s reaction function provides an opportunity to draw conclusions beyond the 12-18 month horizon provided by the correlation between yield curve inversions and recessions because we can make a forecast of the time of inversion. In The Fed’s road to inversion we discussed several routes to a yield curve inversion and recession and decided to make the scenario that the Fed will stop hiking after the yield curve inverts in 2019Q2, after a final hike in March, our baseline. This would signal a recession in 2020Q4.

The Fed’s interpretation of the yield curve gave us the prime suspect for causing the next recession: monetary policy. The FOMC wants to hike until it thinks monetary policy is slightly restrictive. The Fed does not think that an inverted yield curve is a step too far, rather it is a sign of being in restrictive territory. Therefore they are likely to hike the curve into inversion. How many hikes this may take is still unclear. Our baseline scenario is that the curve inverts after the March 2019 hike as the global economic outlook will continue to weigh on the longer end of the curve. However, if the outlook improves this will encourage the Fed to hike again, for example in June. This could still invert the curve, albeit somewhat later. In the end, the combination of a Fed that does not think that inverting the yield curve is a problem and a global outlook that is not likely to improve in a sustained manner is likely to lead to a monetary policy error that will push the economy into recession. Our expectation of a monetary policy error is not based on any specific number of hikes, but rather on the Fed’s stopping criterion.

Conclusion

In recent days the US treasury yield curve has flattened rapidly and at certain segments we are already seeing an inversion. At present, both the 2y and 3y yield are higher than the 5y yield. The 2-10 spread is still 14 bps, but this about half of what it was only a month ago. In the coming months, we expect the 2-10 spread to turn negative as well. That will be a signal to tighten our seatbelts for a hard landing.

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Author(s)
Philip Marey
RaboResearch Global Economics & Markets Rabobank KEO
+31 (30) 2169721

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