Yield Curve more or less flat

In a study (cited by John Maudlinin one of his thoughts from the frontline emails) done by Estrella and Mishkin, the authors predicted the probability of recession by using the spread between the 3 month and 10 year Treasuries.

Prob of Recession -- Spread
5% -- 1.21
10% -- 0.76
15% -- 0.46
20% -- 0.22
25% -- 0.02
30% -- -0.17
40% -- -0.5
50% -- -0.82
60% -- -1.13
70% -- -1.46
80% -- -1.85
90% -- -2.40

So, currently we are at 0.63 spread, which suggests under a 15% chance of recession if you believe the #'s.

I would caution that because of improved information flow, etc... the numbers may be skewed higher as I doubt that the fed would invert the yield curve 2.5% any more (or at least at these low levels). So, chance of recession may be higher than suggested by this chart, if you believe that argument (which I don't hold a strong opinion on, personally).

However, please consider that two more FF hikes of 0.25 each are essentially priced into the market at this point. That would take Fed Funds rate to 4.5%. Assume that 3months stay at slight discount of 15bp and are 4.35%. Also assume that the 10yr goes up slightly to 4.6%. Then, the spread is 0.25, which still only bodes a 20-25% probability of recession.

The key will be if Bernake hikes. Until then, it probably is status quo. You have a reprieve until the spring.
 
Quote from drsteph:

In a study (cited by John Maudlinin one of his thoughts from the frontline emails) done by Estrella and Mishkin, the authors predicted the probability of recession by using the spread between the 3 month and 10 year Treasuries.

Prob of Recession -- Spread
5% -- 1.21
10% -- 0.76
15% -- 0.46
20% -- 0.22
25% -- 0.02
30% -- -0.17
40% -- -0.5
50% -- -0.82
60% -- -1.13
70% -- -1.46
80% -- -1.85
90% -- -2.40

So, currently we are at 0.63 spread, which suggests under a 15% chance of recession if you believe the #'s.

I would caution that because of improved information flow, etc... the numbers may be skewed higher as I doubt that the fed would invert the yield curve 2.5% any more (or at least at these low levels). So, chance of recession may be higher than suggested by this chart, if you believe that argument (which I don't hold a strong opinion on, personally).

However, please consider that two more FF hikes of 0.25 each are essentially priced into the market at this point. That would take Fed Funds rate to 4.5%. Assume that 3months stay at slight discount of 15bp and are 4.35%. Also assume that the 10yr goes up slightly to 4.6%. Then, the spread is 0.25, which still only bodes a 20-25% probability of recession.

The key will be if Bernake hikes. Until then, it probably is status quo. You have a reprieve until the spring.
More...

Thanks much doc ... I read Mauldin from time to time and hadn't come across that. (And I appreciate that it took some time to type all those numbers out.)

Here's what to look for folks: Fed is wary of runaway asset prices as a stealth form of inflation. Assets in their sights include not only housing but oil, gold, metals etc.

As such, a good shorthand proxy for whether they hike beyond December is what oil does next year.

Don't get fooled by the current selloff - Oil is weak on a seasonal basis from Sep to the end of Dec. Remember, we will have another driving season and hurricane season in 2006, and China/India demand continues to grow. (China GDP was 9.4% in the third quarter.)

And the fed has no qualms about inverting per se, when that is what's needed to get the job done.
 
I'm not serious about this but Greenspan should jack up the fed funds rate by 1 full percentage point tomorrow in a suprise announcement. The resulting blood bath in the bond market would be priceless.
 
Quote from drsteph:

In a study (cited by John Maudlinin one of his thoughts from the frontline emails) done by Estrella and Mishkin, the authors predicted the probability of recession by using the spread between the 3 month and 10 year Treasuries.

Prob of Recession -- Spread
5% -- 1.21
10% -- 0.76
15% -- 0.46
20% -- 0.22
25% -- 0.02
30% -- -0.17
40% -- -0.5
50% -- -0.82
60% -- -1.13
70% -- -1.46
80% -- -1.85
90% -- -2.40

So, currently we are at 0.63 spread, which suggests under a 15% chance of recession if you believe the #'s.

I would caution that because of improved information flow, etc... the numbers may be skewed higher as I doubt that the fed would invert the yield curve 2.5% any more (or at least at these low levels). So, chance of recession may be higher than suggested by this chart, if you believe that argument (which I don't hold a strong opinion on, personally).

However, please consider that two more FF hikes of 0.25 each are essentially priced into the market at this point. That would take Fed Funds rate to 4.5%. Assume that 3months stay at slight discount of 15bp and are 4.35%. Also assume that the 10yr goes up slightly to 4.6%. Then, the spread is 0.25, which still only bodes a 20-25% probability of recession.

The key will be if Bernake hikes. Until then, it probably is status quo. You have a reprieve until the spring.
More...

Indeed, excellent post.
 
Two things

Firstly the New York fed has done a study on the predictive abilities of yeild curves. You can read it on their website.

Secondly why is it that the sterling yeild curve inverts all the time seemingly regardless of economic output?
 
Quote from zf trader:


Secondly why is it that the sterling yeild curve inverts all the time seemingly regardless of economic output?
More...

Cannot be. Where is your data? Last two years, maybe, because Bank of England has been trying to kill the housing boom.
 
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