US recession risk to rise in 2023/2024

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. 

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