Recession now—yield curve
Panday et al. 24 (Satyam Panday, Chief Economist in the Global Economics and Research Group at S&P Global Ratings. Shruti Galwankar, Senior Analyst at CRISIL Global Research & Risk Solutions. Debabrata Das, economic researcher. “U.S. Business Cycle Barometer: Recession Risk Remains Above Historical Norm” 6/18/2024. Accessed 6/19/2024. https://www.spglobal.com/ratings/en/research/articles/240618-u-s-business-cycle-barometer-recession-risk-remains-above-historical-norm-13151066) wtk
Our model implies the probability of a recession starting within the next 12 months is 25%-30% (see chart 1). The model is based on key forward-looking financial market indicators and the Organization for Economic Co-operation and Development's leading economic index through May. While the probability of a recession in the near term has fallen since last fall due to easing financial conditions, it remains elevated at twice the unconditional probability of recession (baseline comparison) since World War II. The still-high probability of a recession compared with normal times largely reflects the inverted yield curve (see The Mighty Yield Curve Is Still Inverted).
The Mighty Yield Curve Is Still Inverted
The still-elevated probability of a recession compared with normal times largely reflects the inverted yield curve (see chart 2). In the U.S., an inverted yield curve has predicted seven of the past seven recessions, with no false positives (unlike the stock market, which is well known for its false positives). A few times when the yield spread came close to inverting (for example, in 1995 and 1998), the Federal Reserve responded by preemptively cutting rates, which in hindsight appears to have helped extend the expansion.
Historically, the time between the first month of an inversion and the start of a recession has ranged from six to 18 months. However, this time may be different since this expansion is coming out of a pandemic-induced recession, rather than a more typical recession caused by the business cycle or financial markets. Fiscal policy response (much looser for longer) has been another differentiating factor. Moreover, the Fed's balance sheet policy since the global financial crisis of 2007-2009 may be distorting the usual signal through compressed term premium.
The current yield curve inversion primarily reflects investors' expectation the Fed will eventually have to cut interest rates, which in turn may reflect:
A view that the Fed will go too far and push the economy into recession, or
A view that the Fed has pushed the policy rate above its expected long-run average and that its success in bringing down inflation will allow it to later reverse course.