The San Francisco Federal Reserve has published a report that is generating a lot of buzz in the financial markets. Entitled, “Future Recession Risks,” the paper reviews the predictive capabilities of the US Conference Board’s Leading Economic Index. This report has been cited in several articles providing outlook for a double dip recession and generating additional angst for investors.
As most know, the LEI is published once a month by a private research group in New York City. It is composite comprised of 10 indicators that are known to swing up or down well in advance of the rest of the economy. The concept is to watch LEI and you’ll be able to anticipate where GDP is headed. Today, this is particularly salient given the debate over potential policy prescriptions in anticipation of a new recession that has yet to emerge.
The paper takes an interesting jumping off point: “The predictive ability of each LEI component varies wildly depending on the forecast horizon. For example, the spread between 10-year Treasury bond and the federal funds rate works best 18 months into the future, whereas the initial claims for unemployment insurance indicator works best two months ahead. Clearly, one should give more weight to the rate-spread indicator than the initial claims indicator when forecasting in the long run, but less weight when forecasting in the short run.”
From here, the paper makes adjustments to each indicator and also adds an “odds-ratio” to provide a corrective method to predict a recession.
Here’s the key conclusion: “….the likelihood of a recession is essentially zero over the next 10 months but that the odds deteriorate considerably over the following year. However, even at its worst, the probability of recession is never above 0.3, so that expansion is more than twice as likely as recession.” If you strip out the volatile stock market indicator, the probability of recession drops further.
The paper makes this statement on one key LEI component, the US 10yr Treasury minus the Federal Funds rate: “Historically, this spread, which summarizes the slope of the interest rate term structure, has been a very good predictor of turning points 12 to 18 months into the future. Specifically, an inverted yield curve has preceded each of the last seven recessions.” Given this, the authors still decide to exclude it in one of their alternative scenarios as they believe the yield curve is distorted by flight to quality demand for US Treasury securities. (Click for more on U.S. Treasury prices.)
In this LEI, the probability of a recession increases significantly and indicates that odds of a recession are just slightly more than expansion. It is this point that “Deflationistas” and “New Normalists” have grasped on to for support of their dour view of the future. Even if the yield curve is distorted, wouldn’t the medicinal effect of steep yield curve provide the economic tonic for improving banks balance sheets and decreasing corporate borrowing costs?
The answer is clearly yes. Banks are reporting record profits this quarter and last week the high yield debt market had a record, all time high issuance. Therefore, the exclusion of the spread is not valid, distorts the conclusions and brings to mind Mark Twain.
While the US economic recovery has clearly slowed from it’s earlier pace, the reports of its future death are greatly exaggerated.
Andrew B. BuschDirector,