With high inflation, the Federal Reserve’s accelerated rate-hiking cycle, and the inversion of the U.S. yield curve, investors are increasingly concerned about the risk of a recession. 

Predicting recessions is difficult: while the yield curve has historically inverted before recessions, it has been less useful for timing them. Current high inflation could trigger an earlier and deeper inversion. Since the late 1980s, the lag between yield curve inversion and U.S. recessions has averaged 20 months, so it can serve as an early warning sign. That said, false signals are common. In periods of high inflation, the yield curve has inverted by between 100 bp and 200 bp before a recession, and even a mild inversion can generate a false signal.

Monitoring a broader range of market indicators—including cyclical versus defensive valuations, credit spreads, and federal funds rates—could help gauge the risk of a future recession.

Some indicators based on ​​market-based indicators are leading indicators—the most well-known being the yield curve—while others, such as risky assets, react primarily during or at the onset of recessions. (see footnotes)

As Goldman Sachs notes, the combination of indicators could provide a better signal: So today andn average, both leading and coincident indicators have risen so far this year, but they are not currently placing much weight on the risk of a recession.

The U.S. 10-year/2-year yield curve and cyclical/defensive stocks point to a higher probability of a recession. Market-implied probability of a U.S. recession. All-time high since 1950

Source: Goldman Sachs

Market-based indicators have signaled a higher probability of a recession in the coming year. Market-implied risk of a U.S. recession. Orange shading: NBER recession. Dashed line: unconditional probability

Source: Goldman Sachs

The current market-implied probabilities of a recession are still below the levels that would normally signal a recession. When combining different segments of the yield curve, the market is pricing in a low probability of a recession over the next 12 months, but a 38% probability over 24 months. Historically, cyclical versus defensive valuations have given some false signals; recently, they have likely also been affected by rising commodity prices and supply chain disruptions, rather than just the risk of a recession.

All in all, based on the average of leading and coincident indicators, the current risk of a recession implied by the market does not appear to be very high, especially following the recent strong recovery in risk assets; coincident indicators suggest that markets have priced in a lower risk of an imminent recession.

Recession indicators remain low compared to where they have historically stood prior to recessions. Dotted line = current. Average probability implied by the market around recessions since 1950

Source: Goldman Sachs

Notes:

For coincident indicators, we use the S&P 500’s 1-year drawdown, the excess bond premium, USD high-yield (HY) credit spreads, and the VIX; these rose significantly in the first quarter due to fears of Fed tightening and the war between Russia and Ukraine. However, they have since fallen considerably: the probability of an imminent recession is now priced in at a very low 4%, which increases the risk of disappointment in the event of a sharp slowdown in growth.

For the key indicators, we use the 2s10s yield curve, the implied 12-month forward shift in the federal funds rate, cyclical versus defensive P/E ratios, and MBS spreads. Only the 2s10s yield curve and the cyclical-to-defensive P/E ratios point to a higher-than-normal risk of recession; the others point to a very low risk.

Humberto Mora

Investment, Finance, and Business Manager; Stockbroker