US recession risk to rise in 2023/2024

Kieran Davies

Coolabah Capital

We believe that one of the biggest issues for financial markets in the period ahead is the risk of a recession in the world's largest economy bringing down equity values and other associated asset classes. 

We have developed models to forecast the risk of recession in the US-based on the yield curve and the US Federal Reserve funds rate, which point to the probability of a US downturn increasing in late 2023 and peaking in 2024. Importantly, the current market pricing of the Fed funds rate strongly signals a recession at that point, although a material sell-off at the long end of the curve would greatly reduce the risk given the likelihood of a recession in this framework is determined by the peak in the policy rate relative to long-term bond yields. That said, the curve may still eventually invert given the Fed might need to adopt a noticeably tight policy to bring inflation under control.

Forecasting recessions in the US is difficult, but the most reliable and robust predictor of the risk of recession remains the yield curve, where the yield curve has inverted prior to past recessions.

Some analysts prefer to focus on the curve as represented by the difference between the 10-year and 2-year Treasury bond yields – which is currently on the cusp of inverting – but we find that this representation is outperformed by the difference in yields on the 10-year Treasury bond and 3-month Treasury bill, where even better results can be obtained by including the level of the US Federal Reserve funds rate.

Including the Fed funds rate adds value because it better captures the influence of monetary policy, where the risk of recession is higher if the yield curve inverts at a higher level of interest rates.

More recently, the Federal Reserve has taken a different approach, emphasising the importance of monetary policy by focusing on the very front of the yield curve as represented by the difference in yields on the 3-month Treasury bill in 18 months’ time and the current 3-month bill.

We have developed and estimated a model based on the 10-year/3-month yield curve and the level of the Federal funds rate, which currently puts the risk of recession in the US in a year’s time at near zero. This is not surprising given this broad measure of the slope of the yield curve is strongly positive, with the Federal Reserve only recently starting to raise interest rates.

Using this model, we further estimated the risk of recession embedded in expectations of interest rates over the next couple of years in two scenarios. Assuming in both cases that the 3-month Treasury bill yield moves in line with the funds rate, the scenarios suggested that:

  1. the risk of recession based on surveyed economists’ expectations for the funds rate and 10-year bond yield increases to 13% at the end of 2023 and peaks at 15% in mid-2024; and
  2. the risk of recession based on current market pricing for the funds rate and economist expectations for the 10-year bond yield reaches 21% by the end of 2023 and peaks at 34% in early 2024.

The estimated probabilities based on economist expectations are not a strong signal of recession insofar as that model has predicted peak probabilities of between 28-44% for the past four recessions and where the US economy has been in recession almost 15% of the time in the post-WW2 period.

The estimated probabilities based on market pricing of the funds rate are higher and would strongly signal a recession in late 2023/2024, if realised. The difference in signal reflects the difference in views on the Fed funds rate, where economists expect the Fed funds rate to peak at 2.2%, which is below the market's estimated peak of 3% that is closer to the median FOMC estimate of a 2.8% Fed funds rate by the end of 2023.

The eventual risk of recession will also hinge on how much the 10-year bond yield increases, noting that it is already materially above the peak economists’ forecast of 2.6% (current US 10-year yields are 2.8%). The prospect of higher yields is amplified by the Federal Reserve signalling a faster reduction in the size of its balance sheet and by the possibility that inflation expectations become unmoored.

A material rise in long-term yields would mechanically lower the estimated risk of recession. That said, there is a significant risk of an inversion over the next year or two given the Federal Reserve has already signalled a front-loading of rate rises. 

Tight monetary policy might also be needed to bring inflation under control, particularly if high actual inflation becomes entrenched in high expected inflation. The front-loading of rate rises also reinforces the message from our scenario analysis, which is that at this stage recession risks are centred around late 2023/2024. 

Listen to our latest Complexity Premia podcast episode on the bond market blood-bath in the month of March here...

Access Coolabah's intellectual edge

With the biggest team in investment-grade Australian fixed-income and over $7 billion in FUM, Coolabah Capital Investments publishes unique insights and research on markets and macroeconomics from around the world overlaid leveraging its 14 analysts and 5 portfolio managers. Click the ‘CONTACT’ button below to get in touch.

Investment Disclaimer Past performance does not assure future returns. All investments carry risks, including that the value of investments may vary, future returns may differ from past returns, and that your capital is not guaranteed. This information has been prepared by Coolabah Capital Investments Pty Ltd (ACN 153 327 872). It is general information only and is not intended to provide you with financial advice. You should not rely on any information herein in making any investment decisions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The Product Disclosure Statement (PDS) for the funds should be considered before deciding whether to acquire or hold units in it. A PDS for these products can be obtained by visiting Neither Coolabah Capital Investments Pty Ltd, Equity Trustees Ltd (ACN 004 031 298) nor their respective shareholders, directors and associated businesses assume any liability to investors in connection with any investment in the funds, or guarantees the performance of any obligations to investors, the performance of the funds or any particular rate of return. The repayment of capital is not guaranteed. Investments in the funds are not deposits or liabilities of any of the above-mentioned parties, nor of any Authorised Deposit-taking Institution. The funds are subject to investment risks, which could include delays in repayment and/or loss of income and capital invested. Past performance is not an indicator of nor assures any future returns or risks. Coolabah Capital Investments (Retail) Pty Limited (CCIR) (ACN 153 555 867) is an authorised representative (#000414337) of Coolabah Capital Institutional Investments Pty Ltd (CCII) (AFSL 482238). Both CCIR and CCII are wholly owned subsidiaries of Coolabah Capital Investments Pty Ltd. Equity Trustees Ltd (AFSL 240975) is the Responsible Entity for these funds. Equity Trustees Ltd is a subsidiary of EQT Holdings Limited (ACN 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). Forward-Looking Disclaimer This presentation contains some forward-looking information. These statements are not guarantees of future performance and undue reliance should not be placed on them. Such forward-looking statements necessarily involve known and unknown risks and uncertainties, which may cause actual performance and financial results in future periods to differ materially from any projections of future performance or result expressed or implied by such forward-looking statements. Although forward-looking statements contained in this presentation are based upon what Coolabah Capital Investments Pty Ltd believes are reasonable assumptions, there can be no assurance that forward-looking statements will prove to be accurate, as actual results and future events could differ materially from those anticipated in such statements. Coolabah Capital Investments Pty Ltd undertakes no obligation to update forward-looking statements if circumstances or management’s estimates or opinions should change except as required by applicable securities laws. The reader is cautioned not to place undue reliance on forward-looking statements.

Kieran Davies
Chief Macro Strategist
Coolabah Capital

Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...

I would like to

Only to be used for sending genuine email enquiries to the Contributor. Livewire Markets Pty Ltd reserves its right to take any legal or other appropriate action in relation to misuse of this service.

Personal Information Collection Statement
Your personal information will be passed to the Contributor and/or its authorised service provider to assist the Contributor to contact you about your investment enquiry. They are required not to use your information for any other purpose. Our privacy policy explains how we store personal information and how you may access, correct or complain about the handling of personal information.


Sign In or Join Free to comment