‘We Got No More Liquor!’ These Yield Curve Inversion As A Recession Predictor Probabilities Are Sure To Be A Hit At The Bar

If you’re not talking about the inexorable flattening in the U.S. curve in public settings, well then one wonders what the hell it is you’re saying at the bar when you’re spittin’ game to the waitresses.

I mean, this is all anyone wants to talk about. I don’t hang out in bars anymore because like Richard Pryor, I couldn’t stop drinking until the bartender screamed “WE GOT NO MORE FUCKING LIQUOR!” at me.

 

And I mean that literally. I once drank so much Tanqueray TEN over a 48 hour period at the bar of a local steak house that they ran out of the shit. Of course unless you’ve got a cocktail menu with a drink on it that calls for Tanqueray TEN, that’s not something you keep on hand in mass quantities (you just keep regular Tanqueray), but you get the idea.

 

Anyway, the point is, I don’t really know what folks are talking about at the bar nowadays, but surely to God it’s the yield curve. Nothing makes for better drunk conversation than the curve as a recession predictor – that kind of banter will ensure you don’t stumble home alone.

And when it comes to the yield curve as a recession predictor, the discussion isn’t as cut and dry as a good gin martini. Rather, some folks are now suggesting that the traditional relationships may no longer hold. Still, as Deutsche Bank writes in a new note, “given the yield curve slope’s track record at predicting recessions, there is no wonder why it has such a vaunted place in the minds of economic forecasters.”

Right. So what is it telling us now? Well, that depends on how you break it down. For instance, the following chart from DB is just the yield curve (implying ~30% chance of a recession over the next year), the real policy rate gap (implying ~20% chance), and the risk-neutral and term premium slopes as separate variables (implying ~15% chance):

Curve

Well they’re not happy with the predictive value of that (given that the probabilities weren’t very elevated around several previous recessions) and so, Deutsche uses the extant literature to employ and plot a better model. To wit:

Consistent with academic work on this topic, we consider a more complete recession probability model that includes the real interest rate gap and the two components of the yield curve slope separately. We also include the Chicago Fed National Financial Conditions Index as well as a measure of the corporate bond excess risk premium that helps the model to better fit the data. As we show in Figure 11, despite the relentless flattening of the yield curve, the probability of a recession over the next year remains low with the March data suggesting a roughly 10% chance. This lower level is a result of still accommodative monetary policy and financial conditions and a low excess risk premium on corporate bonds. However, as the Fed’s tightening cycle continues to flatten the curve, recession risks are much higher over a longer time horizon, indicating almost 70% odds of a recession at some point over the next three years.

Curve2

So there’s that, for whatever it’s worth. Of course this all depends on a variety of factors, including whether the Fed sticks to its guns in the face what will likely be intermittent flareups in equity volatility and also on whether, between policy convergence (i.e. the ECB ending APP and moving towards rate hikes), a deluge of supply from Treasury, and inflation pressures, the term premium gets rebuilt.

Now you’re thusly armed with plenty of interesting tidbits to wow the locals with on your next trip to the bar. You’re welcome.

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