Macro 4 minutes to read

More on the yield curve inversion, recession risk and market path from here

Steen Jakobsen

Chief Economist & CIO

Summary:  Here I clarify my take on the recent US 2-10 yield curve inversion - actually an inferior measure of the yield curve - and what this means for the risk of an incoming recession as well as the weighted risk for the market path from here.


More on the yield curve inversion, recession risk and market path from here

My piece yesterday generated welcome feedback and more than a few misunderstandings on what  I was trying to communicate. For the last of these, I apologize and hope that this piece does a better job of clarifying my position on the yield curve inversion we are seeing and the weighted risk of market outcomes depending on whether that inversion is predicting a recession.

Let me stress:

  1. Yield curve inversions are an important recession predictor, but the 2-10 measure is often far less relevant than other measures – like the Fed near term premium referred to yesterday (Fed 3 months less Fed 18 months)
  2. As well, what I am saying is that when recession risk rises and becomes a reality, risk off takes over as investors run for cover: the average drop in recessions is 25%.

I am not predicting a 25% collapse – actually if a recession occurs I think the downside risk could be worse. What I am saying is that, of the potential paths from here we have a more than 50% risk of a  US recession and more than 80% of a Europe one. In risk-weighted terms, that means a weighted risk of -7.5% is the relatively complacent base case scenario for equities from here (50% probability of a recession scenario and -25% drawdown that brings or 50% probability of +10% rally in a no-recession scenario).

My predictions have zero predictive value, but I believe Saxo Bank’s Economic Model is 70% reliable in catching turns in the economy and here our credit impulse has forewarned on recession with its usual nine month lead, which has been our main macro theme in the Quarterly Outlooks and my communication. When economic growth goes into recession risk appetite shifts because of increased velocity of moves and impacts on risk metrics, as well as due to psychology.

So the main points:

  • Inverted yield curves are 7 for last 8 in predicting recessions
  • The average market drop is 25% in recessions
  • The probability of a recession in US right now >50%
  • When yield curve inversions deepen – the probability of a recession increases almost exponentially (see image below)

Please spend five minutes understanding the dynamics from these two charts courtesy of WSJ.COM’s The Daily Shot and directly from Oxford Economics & Piper Jaffray.

Disclaimer

Saxo Capital Markets (Australia) Pty Ltd prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Combined Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Pty Ltd.
Level 25, 2 Park Street
NSW 2000
Sydney
Australia

Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Pty Ltd ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms & Combined Financial Services Guide & Product Disclosure Statement to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products such as CFDs and Margin FX products may result in your losses surpassing your initial deposits. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.
Please click here to view our full disclaimer.