Deutsche: "Recession Risk Is The Highest In Ten Years; It's Time For The Fed To Pause Tightening"

Even before Harvey and Irma were set to punish Texas and Florida, erasing at least 0.4% GDP from Q3 GDP according to BofA and costing hundreds of billions in damages (contrary to the best broken window fallacy, the lost invested capital more than offsets the "flow" benefits from new spending, which is why the US does not bomb itself every time there is a recession to "stimulate growth"), things were turning south for the US economy, so much so that according to the latest Deutsche Bank model, which looks at economic data that still has to incorporate the Irma/Harvey effects, the risk of a recession starting in the next 12 months is near the highest it has been since the last recession.

As Deutsche Bank's Dominic Konstam writes, at first glance, the modeled probability is admittedly low at about 8% as of the end of August (down a touch from near 10% in June), but it has been generally trending higher despite a brief post-election dip. As a result, the bank "sees appeal to buying SPX put spreads and bull flatteners in Eurodollars given the emergence of downside risks."

How does Deutsche estimate recession risk?

"We use a probit model to estimate the probability that a recession will start in the next 12 months using the 1s10s Treasury yield curve, the unemployment rate less CBO’s NAIRU, annual core CPI ex-shelter inflation, aggregate hours worked growth, and the year-on-year change in oil prices. Unemployment’s proximity to NAIRU and soft core inflation are the key factors contributing to the appearance of some recession risk currently. Aggregate hours worked remains on a relatively healthy trend and oil prices are slightly positive year-on-year, however. While it has flattened significantly, the yield curve is also relatively steep."

On the other hand, as we discussed two months ago when observing the imminent Y/Y contraction in C&I loans, traditionally a guaranteed leading indicator of future recessions, other metrics demonstrate a far higher recession risk:

Konstam admits as much, saying that "if we look elsewhere we can find reasons to believe our 8% estimate is too conservative. We noted the slowing in C&I loan growth last week, which has rolled over from a recent peak near 13% to just 1.6% y/y at the end of July. This type of rolling over is consistent with what is typically seen during recessions, not in the build up to them. As we’ve noted, Fed reserve draining against the backdrop of a flat yield curve and potentially tepid loan demand may simply result in an outright contraction of bank lending as banks choose cash assets over loans, which would push this indicator further into what would be “recession levels” by historical standards."

When considering the more practical recession indicators, the Deutsche economist concedes that when working with the bank's rates strategy team, who previously produced a recession probability model that used the yield curve adjusted for the level of yields, shown a few higher recession probability:

Regressing the curve on front end rates shows that the curve is quite flat versus the level of short rates, and when we re-estimate our recession probability model using this metric instead we find a recession risk closer to 20%, having been as high as 25% in the Brexit aftermath. Outside of the last several years, such divergence between the two recession probability estimates has been highly unusual.

So what does the above mean for risk asset returns? Here is Konstam's answer for equities:

Given its construction and purpose to predict recessions over the next 12 months, there should be some forward looking information for asset returns. There is some evidence of a bias in risk assets in the months following a recession probability of greater than 15% (as is currently reflected in the adjusted yield curve probit model). On a 6m look ahead, the S&P sells off 32% of the time since 1968, but that rises to 45% in the 6m following a recession probability of at least 15%, and the median return falls about 2%. A recession probability of 30% is consistent with the S&P selling off 50% of the time. In addition to the negative skew to returns, delivered volatility rises more frequently in instances of an elevated recession probability. We have previously discussed the risk of volatility/ risk-off feedback loops, which the modeled recession risk suggests are a higher likelihood in the months ahead.

Next, for junk bonds:

High yield widening increases in frequency from 47% to 65% (since 1985) after conditioning on a 15% recession probability, and the median 6m change is a 40bp widening (versus ~10bp tightening unconditionally). Note in high yield there is a significant increase in probability of widening up to +250 bps (to date recent widening is quite muted, around +30 bps). Despite these biases in risk assets, there is less evidence of any consistent behavior in yields or FX when the recession probability breaks above a given threshold.

The biggest take-home message, however, is what these rising recession odds mean for the Fed's upcoming tightening actions, and while there is a discrepancy between various measures and indicators of recession risk which in turn complicates the ability to draw a firm conclusion, there are enough warning signs for Deutsche Bank to say that this uncertainty in and of itself "furthers our argument that the Fed would do well to take a pause in its tightening for the time being." 

In other words, a Fed Funds rate just above 1.00% may be all the massively levered US economy can take before rolling over into recession, something first suggested by the various R-star analyses conducted here in 2015. It also means that in just a few months the US may be discussing NIRP and QE4 all over again.

DB's conclusion: "while we are relatively optimistic in our medium term equity view – falling equity risk premia in a low inflation equilibrium world mean equities are more likely to rally to bonds than bonds sell-off to equities – we maintain our near-term caution. While we don’t see recession as imminent, the blinking yellow lights mean that upside may be contained for now."


ET (not verified) Sat, 09/09/2017 - 11:56 Permalink

Banks profit by printing money and confiscating people's purchasing power through the magic of fractional-reserve banking.Nonetheless, too high of an inflation could lead to popular discontent and an investigation of banking systems that could topple the money-printing schemes.The idea is to become a parasite, feeding on the host. Killing the host is against the bankers' interests. The parasite would not survive for long without a new host from which to feed itself.The bankers have determined that a two percent annual wealth extraction from the host would largely go undetected. And this is how we get the Fed inflation target of two percent.

ET (not verified) CRM114 Sat, 09/09/2017 - 12:20 Permalink

The rate of inflation may have to be much higher for people to start questioning the whole banking system.In Venezuela there is not much talk about sound money. The people want more and more money, however much devalued it is, to keep up with the rate of inflation, thereby creating a positive feedback loop.Also, crypto is not the answer. Coinbase and other crypto exchanges are Ponzi schemes.Read the reviews. Very difficult to get money out of the exchanges.

In reply to by CRM114

Vlad the Inhaler ET (not verified) Sat, 09/09/2017 - 12:26 Permalink

At this point, too high of inflation would do a lot worse than get people's attention.  It would get the attention of the bond market and the global pool of money rotating out of equities, so that the Fed would not be able to respond to a stock crash with more QE, and that's their worst nightmare.  So basically we are stuck in stagflation until the system breaks.

In reply to by ET (not verified)

CRM114 Sat, 09/09/2017 - 11:55 Permalink

Serious question on the 'broken window': If the invested capital that is lost is mostly all (effectively) the newly printed QE, perhaps it does make sense to bust the window, especially as the money spent on replacement is more likely to end up in the pockets of ordinary workers like glaziers and construction guys?Is this not, effectively, trickle down? Has QE now actually made it economically sensible for the US to bomb itself?

kenny500c CRM114 Sat, 09/09/2017 - 12:23 Permalink

You can get a short term bounce in GDP by borrowing and spending but the money at some point has to be paid back with interest.But in the current economic environment we are getting very little growth from borrowing and have accumulated a $20+ trillion deficit. My guess is that all profits have to go to paying back principal and interest and not to re-investment.

In reply to by CRM114

jmack CRM114 Sat, 09/09/2017 - 12:37 Permalink

  You have merely stumbled into one of the BIG LIES™.   They called Reagan's supply side economics trickle down, but that was merely projection, or more likely, a malicious lie.       What they called trickle down economics, was actually removing middle men from between wealth creators to other potential wealth creators, allowing capital to grow with a minimum of parasites leeching off of it.    What we have now is trickle down, where the government "allows" people to succeed as they chose, so that those that wish to succeed must be compliant to the government.      The whole system has been corrupted, but it is too powerful to reverse, few even realize what really needs to be reformed, and unless you can get critical mass in the education of the population, on the scale of a cultural shift, then you cannot reverse course, and the only option is to let it collapse in on itself, much like Venezuela, and be prepared to be effective when the opportunity for a reset occurs.

In reply to by CRM114

jmack grasha87 Sat, 09/09/2017 - 14:50 Permalink

    An interesting concept, but it is a change to a system.  The underlying problem is that the powers that be have burdened us with this system for a reason, and they will not allow a change to the system until they are no longer the powers that be.  It is the same problem that anyone that trys to "reform" something in DC, runs into.      Instances like Dodd/Frank, Obamacare, or homeland security, are prime examples where a deficiency with the system was percieved, but the people that implemented the "reform" were the same people operating the deficient prior system, and their "reform" was nothing more than an expansion of their power over the larger system.  The system cannot be reformed properly, until the people operating the current system are replaced with adherents to a better system, or at least an allegiance to a better process to develop a new system.  

In reply to by grasha87

zzzz88 Sat, 09/09/2017 - 11:56 Permalink

tigthening or not, the recession will be here, the same as life cyclebecause of central banks stupid policy of last ten years, next one will be very big. it is called T theory---the higher it flys, the hard it drops.

Ink Pusher Sat, 09/09/2017 - 12:07 Permalink

Ahhh, so that's how it works...The Douche Bank makes the call and the FED is supposed to listen and then capitulate?Fuck the douche and all their shareholders.

Soul Glow Sat, 09/09/2017 - 12:09 Permalink

Pause tightening?  It has taken the Fed 8 years to raise rates 50 bps!  How about the Fed, Cogress, and Trump grow a pair and fucking raise rates already!

onthedeschutes Sat, 09/09/2017 - 15:25 Permalink

Definitely time to pause...real estate prices in my area have only doubled in the last five years.  Real inflation is only north of 10%  Yup...time to step on the gas.  Rat bastard central bankers all need to swing from the nearest yard arm.

ilovetexas Sat, 09/09/2017 - 12:32 Permalink

When the big banks repeatedly warn about recession, recession is probably not near. The market will sincerely head lower when these big banks become optimistic.

silverer Sat, 09/09/2017 - 15:29 Permalink

More cheap money! Issue more debt! Yeah, that's it! That's the ticket! Force all the old retired people to liquidate their investment capital to pay daily bills, as they no longer earn a decent return on their money! Can't leave a lot of money to their kids when they die, because then their kids won't have to work and be debt slaves! Gotta start 'em broke and keep 'em broke!

hanekhw Sat, 09/09/2017 - 16:25 Permalink

Well certainly for Germany who  will have to set up separate markets for goat and burka futures and Jihadi and Haj contracts. Notice how most Muslims don't HAVE a bank and their trade and banking transactions have gone on successfully for hundreds of years and how much honor (Deutche's big problem) plays a part?