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:
- 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)
- 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.