April 2022

Prior to each of the past six U.S. economic recessions, the yield on 2-year U.S. Treasury notes has risen above the yield on 10-year U.S. Treasury bonds—a situation commonly known as a yield-curve inversion. While a yield-curve inversion is not a guarantee of recession, the recent inversion of the 2-10 year U.S. Treasury yield curve has led many to ask about the probability of a near-term recession.

The Historical Probability of Economic Recession in the U.S.

1. Since 1948, the US economy has entered recession in 12 different calendar years, or 16% of all years during that period.
2. Since 1980, the economy has become less dependent on manufacturing as a source of jobs and household income. (Over this period, manufacturing as a percentage of employment has decreased from around 20% to 10%.) As a result, the economy has become less cyclical with the length between recessions increasing. Over these 42 years, the economy has entered recession seven times (or 13% of years).
3. The New York Federal Reserve publishes an index that measures the probability of recession over the next 12 months. This index is based on the 3-month, 10-year Treasury yield curve—historically a superior economic indicator than the more frequently cited 2-year, 10-year Treasury curve. The long-term average of recession probability, as measured by this index, is about 14%, which corresponds to the historical record.¹

Our View on the Current Probability of Recession

1. We view the probability of a near-term recession (i.e., that the economy enters recession over the next 12 months) as no greater than the long-term average probability that the economy enters recession.
2. The likelihood of recession will increase as the effects of the Federal Reserve’s commitment to bring down inflation—via interest rate increases and balance-sheet reductions—course through the economy.
3. The economic effects of those efforts are likely to appear with a lag of several months from when the efforts begin. The probability of recession, therefore, should increase above its long-term average in mid-to-late 2023.

Signals for Identifying Increasing Odds of Near-Term Recession

In addition to aggregate indicators such as the Conference Board’s Leading Economic Index, we will watch related individual indicators to assess the odds of recession. Each has provided meaningful recessionary signals since their inceptions. Based on where these signals stand today, we do not see high probability of recession within the next 12 months.

Financial Conditions Indexes

As the Federal Reserve tightens policy, financial conditions should tighten broadly across the economy. These conditions include, but are not limited to, short-term lending rates, corporate bond spreads, and consumer lending rates. As these conditions tighten, ensuing economic activity—including business investment, home purchases, and mortgage refinancing—will slow.

The chart below shows financial conditions as measured by the Kansas City Federal Reserve Bank. Tightening of financial conditions tends to precede recessions. By historical standards, today’s conditions can be defined as  “loose”  but are likely to tighten over the coming months.

Purchasing Manager Indexes—Manufacturing & Services

Purchasing manager indexes (PMIs) provide insight into prevailing trends in the economy, with indexes available both for the manufacturing and services sectors. Manufacturing PMIs have exhibited downward trends before each of the five recessions since 1980. Services PMIs have exhibited similar trends preceding recessions since that index’s inception in 1997.² Important to note, however, is that not all downward trends in these figures have led to recession. Assessing the levels of these indexes, in connection with their direction, is critical.

While both measures have slowed over the past three months, they are retreating from historically high levels and do not indicate economic contraction within the next 12 months.³

Changes in Employment: The Sahm Rule

A third indicator offers even stronger support against increasing the probability of recession beyond its historical average: changes in employment.

By nearly all measures labor markets are tight:

• Unemployment is historically low: 3.6%.
• Underemployment (involuntary part-time employment) is at a 20-year low: 2.5%.
• The labor participation rate has increased to 60% (from 58% a year ago).
• Recent jobless claims were the lowest since 1968.

The Sahm rule is a useful indicator for gauging adverse changes in the labor market. This rule measures changes in the unemployment rate over a trailing three-month period relative to its trailing 12-month low. Positive readings indicate weakening labor markets; readings above 0.5% (a one-half percentage point increase in unemployment) have preceded all recessions since the rule’s inception in 1959. At its current level of -0.1% the Sahm rule reflects the strengthening, not weakening, of the labor market. Absent weakening labor markets, we view the probability of near-term recession as remote.

The Next 12 Months: Slowing Growth Is Likely, Yet Recession Is Not

Our view: Over the next 12 months, economic growth will slow, consistent with entering later stages of the business cycle. We find support for this view in at least three places:

1. The Bond Market:
   1. Government bond markets are not a haven for speculators. Rates and curves are telling us that inflation will move lower, and that growth will slow.
   2. What else could go wrong for U.S. Treasury bonds? Inflation is at a 40-year high, and the Federal Reserve is set to begin raising interest rates. Yet, we are stuck with yields below 3%.
2. Housing: Mortgages rates have increased over 50% to more than 5% on a 30-year mortgage. While low supply should provide some ballast to home prices, higher rates will slow refinancing considerably—and the ability of consumers to tap into home equity to support spending.
3. Consumer Spending:
   1. Personal savings (as a percentage of income) have declined to long-term averages.
   2. For consumers to spend at the same rate, savings must fall farther, or consumers must find additional sources of income.
   3. To support continued spending, some consumers have tapped their home’s equity via “cash out” mortgages. Higher mortgage rates, however, raise the cost of this source of spending cash.

Concluding Thoughts

As our recent Insights piece noted, investors are “Sorting Through the Headwinds” as they assess the course of the economy and the outlook for markets. These headwinds have combined to produce growing concerns over near-term recession. We view the probability of a near-term recession (next 12 months) as no greater than average. However, the Federal Reserve’s actions to tame inflation are likely to raise the recession odds as we move through 2023. Therefore, we will be monitoring the recession signals included above for signs of slowing.

¹ As of March 31, 2022.

² Measured on a rolling 12-month basis, 12 months before official start of economic recession.

³ While the first two indicators (financial conditions and purchasing-manger indexes) have weakened over the first quarter, they have not weakened to the extent that would cause us to increase our odds of recession. While directionally negative, the absolute levels of both indicators suggest economic expansion, not contraction.

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