Recession Odds Pass Key Threshold

Key Points

  • The yield spread rose for many countries in October, a key indicator that the risk of global recession and accompanying bear market in the coming year diminished during the month.
  • Central bank policies have resulted in a neutral effect on the signal from the yield curve.
  • We believe a global recession and accompanying prolonged bear market is unlikely over the coming 12 months.

Global stocks fell almost 2% in October, measured by the MSCI AC World Index. However, a reliable historical indicator suggests October may have been more soothing than scary for long-term investors. The yield spread—the difference between long and short-term interest rates—rose for many countries in October, a key indicator that the risk of global recession and accompanying bear market in the coming year diminished during the month.

Yield spreads rose in October

Yield spreads rose in October

Source: Charles Schwab, Bloomberg data as of 10/30/2016.

Reliable indicator of recession

Historically, the difference between short and long-term interest rates has acted as a reliable indication of a recession in the coming year for economies around the world. Usually, as the gap between short-term and long-term interest rates narrows, the higher the probability of entering a recession within the next year, as illustrated in the table below.

Yield spread suggests diminished odds of a recession in the next 12 months

Yield spread suggests diminished odds of a recession in the next 12 months

All yield spreads calculated as 10 year less 3 month yield except Mexico (5 year less 3 month).

Historical time period begins: U.S. 1967, Eurozone 1970, Germany 1970, UK 1970, Sweden 1970, Mexico 2000.

Source: Charles Schwab, Macrobond data as of 10/30/2016.

Among many of the world’s largest economies, the chance of a recession over the next 12 months is currently indicated to be around 20-40% by the yield curves. While that is above zero, it is important to keep in mind that the chances of a recession are never truly as low as zero, and the current probabilities are meaningfully below 50%.

As of the end of October, the widening of the gap between short and long-term interest rates to 1% suggests a lower risk of a global recession in the next year compared to the end of September. Although the historical probability of a recession is not materially different between the 0 to 1% range and the 1 to 2% range (with the exception of the UK), the rise puts yield spreads further from negative territory where the probability of a recession has been high.

Trick or treat

The jump in the yield spreads during October was partly the result of being treated to better economic data released during the month, but also may have been the result of central bankers having fewer tricks up their sleeves.

Although current interest rates in many economies are very low in absolute terms (and even negative in some), the yield spread has been a useful indicator of a forthcoming recession at all yield levels. Nevertheless, some investors may wonder if central bank manipulation is biasing the signal from this time-tested indicator. Fortunately for investors, since negative interest rates have pulled down short-term rates in some countries to below zero and “QE” bond buying programs have pulled down long-term yields, these two policies together appear to at least somewhat offset each other in their impact on the yield spread. In our view, that means central bank policies have resulted in a roughly neutral net effect on the signal from the yield curve.

Central bank policymakers have acknowledged there are adverse impacts accompanying negative interest rate policy and have also noted that QE can’t go on forever. So, these distortions may begin to diminish, rather than increase, as we look to 2017.

Measuring the distortion

It is easy to see the amount that short-term rates are negative due to negative policy rates in the Eurozone (which includes Germany), Sweden, and several other countries. However, the amount that QE has been pulling down longer-term rates is not directly measurable. To try to assess this impact we observe that when the ECB adopted their QE program in March 2015 a gap emerged in what had been a tight relationship between the futures market expectations for the timing of a rate hike by the ECB and long-term bond yields in the Eurozone, as you can see in the chart below. The amount of this gap suggests that longer-term yields have been pulled down by about -0.5 to -1%, which is similar to the -0.75% short-term yields in the Eurozone and Sweden that are a result of negative interest rate policy.

Eurozone 10 year bond yields lower than implied by expectations for timing of first rate hike after ECB adopted QE

Eurozone 10 year bond yields lower than implied by expectations for timing of first rate hike after ECB adopted QE

Source: Charles Schwab, Bloomberg data as of 10/30/2016.

Bear market unlikely

The yield curve is likely to remain a useful (though not perfect) indicator of recession even with the impact of central bank policies on short and long-term bond yields. We believe a global recession and accompanying prolonged bear market is unlikely over the coming 12 months. That is good news for investors spooked by fear of a bear market and suggests long-term investors should stick with their diversified asset allocation and rebalance as needed.

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