“This Time Is Not Different” – Saxobank Warns The Temporary Calm Won’t Last Long

Monday, February 18, 2019
By Paul Martin

by Christopher DEMBIK
ZeroHedge.com
Mon, 02/18/2019

Investors seeking to track the probability of an incoming US recession must familiarise themselves with the yield curve, a key indicator.

Based on the market’s favorite indicator, the yield curve, the risk of US recession is becoming increasingly credible. Hopes for growth improvements may vanish quickly if policymakers don’t step in to stimulate the economy

Negative wealth effect due to lower house prices
Recession probability models for the US have been all over the place of late. Saxo Bank uses the recession probability tracker from the Federal Reserve Bank of New York, which tracks the difference between 10-year and three-month Treasury rates, to assess the likelihood of an economic downturn. It has recently been updated and stands at 23.62% in January 2019.

Over the past two months, the risk of recession has significantly increased due to market panic linked to the Fed’s monetary policy path. The index stood at just 14.1% in October 2018, then moved to 15.8% in November and jumped to 21.4% in December during the market turmoil. It is still below the threshold of 28% that has been systematically associated with recession over the past 50 years, but it is moving quickly towards this level.

To predict the likelihood of a recession, investors usually pay a lot of attention to the two-year/10-year spread, which is the most common indicator used. However, based on most research papers published by the Fed, we favour the one-year/10-year spread as more relevant.

In normal economic conditions, the yield curve sloped upward, with 10-year Treasury bonds paying higher interest rates than the one-year bonds. But during economic downturns, short-term debt tends to have higher rates than long-term debt due to risk aversion.

Since 1970, each US recession has been preceded by an inversion of the curve. Its track record is quite impressive, with few fake signals (the credit crunch in the mid-1960s and the short-term inversion during the 1998 stock market crash).

Looking at the one-year/10-year spread, the curve is not inverted yet. As of today, it stands at +6 basis points but clearly follows a downward trend. That being said, it means that the risk of recession is becoming real but, based on the previous decades, this would only happen in several quarters. Historically, the lag between the inversion of the yield curve and the recession is on average 22 months. If history repeats itself – which is not certain – the likelihood that a recession happens in 2020 is very high.

This time is not different
Asked about the flattening trend in yields in July 2018, Fed chair Powell, like his predecessors Bernanke and Yellen, took a “this time it is different” outlook on signals sent by the bond market, indicating that the shape of the yield curve will not influence normalising interest rates and the balance sheet. He confirmed at this occasion that “what really matters is what the neutral rate of interest is”.

Over the past few years, it has been very popular among US policymakers to dismiss the curve, both because QE has depressed the term premium, thus artificially flattening, and because there are distortions caused by a preference for safe-haven assets, notably the US 10-year Treasury bonds (negative risk premium).

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