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Returning to the continuing debate about a ‘Double Dip’ recession, I thought we would look at one of the most basic models of the business cycle: the yield curve.
Put simply, the yield curve theory says that if long term rates are lower than short term rates, then the central bank is forcing the economy to slow down. And if short term rates are lower than long term rates, as we they are now, then the central bank is reliquifying the economy and priming future growth. So within the yield curve we have a simple but effective economic indicator.
We’ve already looked at several models which attempt to predict the economic future. Among these are the ECRI’s WLI, MacroAdvisor’s recession probability model, and finally the “Anxious Index”. Of these, all are in agreement that there will be no new recession.
Another model is based on the yield curve and it too agrees with the others that the probability of a new recession is extremely low. Considering the extremely steep slope of the yield curve, this isn’t surprising. To be more precise, the model puts the probability of a new recession at just 0.06%:
Source: New York Fed (with thanks to Mark Hulbert)
This is based on research by Arturo Estrella and Frederic S. Mishkin (see report below) which looks at the relationship between the yield curve and the occurrence of recessions.
The other time in recent history that we had a double dip recession was early 1980’s. NBER dates recessions in hindsight of course, whereas this is a prediction model that attempts to find them ahead of time.
In August 1981, at which point NBER would denote to be the start of a second recession (Double Dip) much later in time, the yield curve model was predicting that the chance of a recession to be 3.6%. In September, one month after the recession had already started, it jumped to 11.3% and two months later, in October 1981, it jumped again to 37.6%. By November 1981 there was little doubt with a 75% probability.
In a recent interview, James Stack of InvesTech, reminds us that all this talk of a ‘Double Dip’ is common during the first stage of an economic recovery. Stack is a market technician whom I respect, and for what it’s worth, he’s continuing to be fully invested with a 95% allocation to equities.
Of course, all of this is no guarantee of any sort. As it was in the early 1980’s, we could see more than just a deceleration and an outright recession (again). But at the moment, everything I’m looking at, including the ECRI’s often cited WLI is not giving us enough reasons to assume that.
The disconcerting thing is, as James Mackintosh points out in this video from FT’s Short View, today the Federal Reserve has basically no room to cut rates further. The only other option, faced with a recession, is “QE II: the Re-reliquefaction”. Otherwise known as Helicopter Ben’s Last Stand.
Here is the explanation of the predictive model mentioned above:
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