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

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.