Tuesday, May 24, 2016

Yield model model for recession - another zombie?

One of the key models used by many investors for business cycle analysis is the change in the shape of the yield curve. An inverted curve sends a strong advanced warning signal of a potential slowdown. This  yield curve model can be translated into a probability measure for a recession, but like the Fed equity valuation model, it may be a zombie model.

It walks around in the modeling environment as if it is a lively useful tool, but in reality, it may be dead as a forecasting signal. It is not a zombie because it has not given a signal since the Financial Crisis. It is a zombie because it does not provide a market-based signal of demand and supply for credit along the term structure.

With unconventional monetary policies keeping rates lows and with a zero bound, it is virtually impossible to get an inverted yield curve. The probability of a recession will never rise above a meaningful threshold without the Fed raising rates further.

We have looked at periods of falling spreads as new indicator, but the evidence is mixed. There can be a consistent decline in spreads without a recession. The inversion has been the key past signal.

No comments: