The Flaw In The Fed Model: Recession Odds Are Far Higher Than Widely Believed

Tyler Durden's picture

Ask the Fed what market indicators are implying about recession odds and it will tell you: about 4%. There is one problem with the Fed's model: as Deutsche Bank's Dominic Konstam shows, it is wrong due to the Fed's own intervention in the yield curve.

To disentangle the Fed's reflexive meddling in market signals, DB writes that it "had a critical look at the Fed’s model for the probability of recession given the shape of the yield curve. Our findings suggest that the current model, which estimates the probability of recession at only 4%, is biased to the downside by the structurally lower level of rates."

So what is the real recession probability? DB explains:

In a special report published earlier this week, we noted that today’s near-zero interest rate regime does not allow the yield curve to freely invert or even flatten too much because of certain structural limits. For example, liabilities-driven investors who in the past could receive long rates below the fed funds rate can no longer do so once rates are floored at zero. Investment fund managers are also restricted by mandates from buying negative yielding assets that lead to mark-to-market losses on their portfolios. Pension investors, who must target returns based on liability assumptions, have been driven into high yielding non-core rate assets as their discount rates are stubbornly and unrealistically high compared to Treasury yields. These factors keep the curve artificially steep even though both short and long rates have been clearly trending downward over the years.


To address the artificial steepness of the curve we corrected the 3m10y spread for the level of the rates. Specifically we regressed the spread against the short rate, leaving the residual which by definition removes for the bias of the rate level and is centered at zero. Using this new curve as model input, we found the probability of a recession in the next 12 months is 46 percent, considerably higher than the original Fed model has predicted.

It gets worse: with every drop in 10Y yields, the odds of a recession rise; this is particularly notable today because as we showed earlier with yields plunging to 10 month lows, the market is actually screaming a recession is just over the horizon:

So what are the bodey levels? Keep an eye on 1.50% and 1.00%: if the 10Y slides that low, it means recession odds soar to 59% and 71% respectively:

As it may be useful for investors, we attempt to handicap the relationship between the yield curve and future recessions captured in our model. Holding the 3m rate constant, every 25 bps rally in 10s (implying an equal flattening in 3m10y) raises the recession probability by 6 percent. If 10yr yields rally to 1.50%, our model predicts a 59 percent chance of recession in the next 12 months; at 1.00% 10s, the probability is 71 percent.


Check to you, dear apolitical, "policy mistaken" Fed.

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ejmoosa's picture

The only indicator you need to understand is that year over year profit growth is negative.

Companies are in business to grow profits, and if they are shrinking they will right size their business plans to return to growth.

That behavior leads to a recession every time.  One year from now they will still be trying to figure out why they missed it.


back to basics's picture

The probability of a recession over the next 12-18 months is 100% because we are in one already.

Fuck burying your face in models, graphs and shit, just lift your head up and look around.

ejmoosa's picture

One of the big issues is that these "Fed Folks" live in big cities.  They stay towards the center of those cites.  What they do not do is get to the suburban and rural areas where the economies are near death.  

Bay Area Guy's picture

Exactly. There are parts that aren't, such as here in the SF area, that are in decent shape. But the country as a whole is hurting. When, not if, the tech bubble bursts, the SF area is going to get hit big time since about 90% of its eggs are in that basket.

JRobby's picture

Exactly, what good are indicators of future events when you are already in the event and have been for 90+ months?????

It is a depression. FDIC, SSA, EIC, UI, Food Stamps, Medicade, Sect 8, etc., etc. is why it does not look exactly like the 30's.

ejmoosa's picture

We do an excellent job of masking the symptoms of the disease, don't we?  But in the long run,...

JRobby's picture

Patient on life support for 8 years. Lost track of the number of "transfusions" but there have been 3 large one's we know about so far.

An ordinary hospital would have pulled the plug.......

ejmoosa's picture

Not when you can print the money to pay the bills...

Squid-puppets a-go-go's picture

DB, go fuck yourself you tools. Recessions happen every 5 years on average, longest without 9. We're over 7 years into this worst ever macro 'recovery' and you still think less than 50% chance of a recession in the near future

does anyone in the financial industry remember the definition of the word 'prudential' anymore?

Bastiat's picture

SNAP cards and bogus SS disability payments--the digital breadline.

dimwitted economist's picture

it's a recovery...

these are not the droids you're looking for..

Move Along..

TheDanimal's picture

Whose team exactly is the Fed on? It hardly makes sense to torpedo the economy in an election year with a sitting Democrat president if they are behind the Democrats. Unless, of course, they are just that incompetent over at the Eccles building.

Vlad the Inhaler's picture

They have to either torpedo the economy or the currency, so which do you think they'll choose for their banker cronies?  Deflation is just an opportunity for them to pick up more rent seeking assets on the cheap.

Chuckster's picture

You need to go re-due your "indicator" professor.  Odds of resession depression collapse are 100%.  What do you think negative interest rates are telling you?  You are brainwashed like the rest.  quit acting like a low grade moron!

Tinky's picture

I want to make sure that I am clear on the topic. The Fed believes that there is a 4% of something occuring which is already, at this very moment, happening?


franzpick's picture

Depression odds rising much faster.

silverer's picture

Especially since we're already in one.

Rainman's picture

*morning chuckle*...remembering November 2008 when the 10y going under 3 was the big headline :

               ' The closely watched 10-year note rose 1-3/32 to 106-18/32, and its yield fell to 2.99% from late Tuesday's 3.10%. The yield on this note has never gone below 3% in its 46-year history.'  ~ CNN Money

JamaicaJim's picture
"Widely Believed"

If you are including the average stupid American, that would apply.

On here? Much less "believed".

If it weren't for every single central fucking bank printing clown bucks, this shit show would grind to a fucking halt damn quick.

Postponing the inevitable.....the culling needs to happen.

Buster Cherry's picture

If this shit show would have been allowed to auger into the earth in 2008, we'd probably be recovered by now.

Pogo5187's picture

We be basically on de same page, mon, but you need to trim bok on de ganja, mon.  And maybe de dreadlocks.

Buster Cherry's picture

I see a very visible in my face recession happening now, in real time, while looking out my Houston, Texas office building window.

silverer's picture

Pull a Baron Danglars! Buy! The next big laugh is when we find out who the next host of the upcoming four year shit show is going to be.

Pogo5187's picture

My infallible PMP (Pogo Market Prognosticator) has the "odds" of a "greater DEpression" @ 100%.  You heard it here first.  And no subscription fee!!!

moonmac's picture


If this isn’t a recession and it’s the new normal then my job just got a lot easier because our factory is dead. During the boom it was crazy stressful, then the crash made my job easy. Stimulus brought the stress again but now sales are back in the gutter so using deodorant isn’t even a requirement. We’re straight salary so when it’s real slow like this I feel a little uneasy collecting a check. Workers OT was cut so stretching $10/hr will limit their families spending which isn’t good for the economy. From what I see we’re so doomed it isn’t even funny!

Iconoclast421's picture

All you have to look at is PCE. No need to make it more complicated than that. You can also glance at the Philly Fed state coincident indexes.

Dg4884's picture

I own a small intl. audit & advisory firm and have seen this over the past two years!  I focus on SMB, and regs along with zero lending have cut some of my clients off at the knees.  By the grace of God, we are hanging in there, but the new hire I was planning on for 2016 is looking more like a fantasy than reality.

Keep 'em dry.

yogibear's picture

Obama and his people say the recovery is doing well.

Wonder what his idea of a recession is. Maybe riots in the streets  a bank holiday and looting is the Fed's soft patch.

PoasterToaster's picture

Did they forget that by their own model there is always a recession every 6-8 years?  Did they really believe this time they could avoid the things that they themselves are doing to create it?

After everything that has gone on, they chose to pretend that recessions are over forever.  What the hell is wrong with these idiots?  They can't even manage halfway decent propaganda, which is their main tool of economic influence.

honestann's picture

Chance of depression == 96%.
Chance of recession == 04%.
Chance of recovery == 00%.

Vin's picture

"...Fed model..."  HAHAHAHAHAHA!

Like they're trying to make things right for us.  HAHAHAHAHAHA!!