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In One Chart - August 29, 2018

In One Chart: Fed’s Best Recession Predictor

Economic uncertainty has been plentiful in 2018.

Those worried about a recession will point to trade wars and hawkish interest rate hikes as reasons to expect economic downturn. On the contrary, others say the recent trade accords with Mexico and overall growth in the stock market signal a strong economic outlook.

Even while major indices like the S&P 500 (^SPX) and Nasdaq Composite (^IXIC) continue to climb, many investors are worried about the possibility of recession due to a narrowing treasury yield spread.

In the chart below, the 10 Year-3 Month Yield Spread is shown in blue, the 10–2 Year Yield Spread in orange, and the S&P 500 in red. Even as the S&P 500 soars, both term spreads are quickly trending down.

The 10–2 Spread is a favorite for predicting recessions and currently stands at 0.21%. When it goes below 0.00%, which is called an inversion, an economic recession has historically followed.

However, a recent Economic Letter issued by the Federal Reserve Bank of San Francisco showed that the 10 Year-3 Month Treasury Yield Spread, not the 10–2 Year Spread, is the superior recession predictor.

It’s important to note that both spreads have historically inverted before a recession, as is shown above for the recessions of 2001 and 2008–09. The significance of the FRBSF Letter is that the 10 Year-3 Month Spread is the superior spread for predicting a recession within the following 12 month period.

While both term spreads are trending down, the 10 Year-3 Month Spread (currently 0.73%) has more wiggle room before reaching inversion — that gives confidence to those who say we are not on the verge of a recession.

Fed officials and market commenters largely agree that the narrowing spread is due, in part, to the market incorporating future rate hikes into current debt prices. As the Fed raises short-term interest rates, short-term yields (like those of 3 Month Bills and 2 Year Notes) will rise. Because long-term debt is not affected by rate hikes as quickly, yield spreads have, in turn, shrank.

As you might remember your high school statistics teacher preaching: Correlation is not causation. Even the Fed’s economists are unsure about the extent of a cause-effect relationship beyond the correlation between yield spreads and economic recessions.

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