How Reliable is the 58-Year High Recession Probability? Investors Brace for Economic Storm
As investors navigate the complexities of the stock market, the Federal Reserve Bank of New York’s recession probability tool has emerged as a crucial metric, signaling potential economic challenges ahead. The tool, which assesses the spread between the 10-year Treasury bond and three-month Treasury bill yields, has gained attention for its historical accuracy in predicting U.S. recessions.
Typically, the Treasury yield curve slopes upward, reflecting higher yields for longer-maturity bonds compared to short-term bills. However, when the yield curve inverts, with short-term T-bills yielding more than longer-dated T-bonds, it raises concerns about the economic outlook. While not every inversion leads to a recession, every post-World War II recession has been preceded by such an inversion, making it a crucial indicator for economic downturns.
The New York Fed’s monthly updates to its recession-forecasting model reveal a significant inversion in the Treasury yield curve, marking the steepest in over four decades. The model now places the probability of a U.S. recession by or before December 2024 at 62.94%. Although the Treasury spread has misjudged a recession once in October 1966, its track record since 1966 has been remarkably accurate, with every probability surpassing 32% leading to an ensuing recession.
With the current probability nearing 63%, concerns are rising among investors about the possibility of a recession in 2024. While the U.S. economy and the stock market are not perfectly correlated, historical trends suggest that corporate earnings tend to decline during recessions. Additionally, a majority of the S&P 500’s significant drawdowns have occurred post-recession declarations, indicating potential challenges for stocks if a recession materializes this year.
Beyond the recession indicator, the Federal Reserve’s monetary policy also plays a significant role in shaping market expectations. The central bank’s actions, particularly changes in the federal funds rate, influence investor sentiment. A declining interest rate environment, often viewed positively by investors, stimulates lending and economic growth. Conversely, a rising-rate environment can signal an economic slowdown.
The Federal Reserve’s historical pattern of lowering interest rates in response to economic challenges adds another layer of concern for investors. While lower rates may initially seem attractive, recent history suggests that they could foreshadow poor stock market performance. The central bank’s forecast for three rate cuts in 2024 raises questions about the road ahead for Wall Street.
Examining the Fed’s recent rate-easing cycles, initiated in 2001, 2007, and 2019, reveals that each time, it took considerable calendar days for the S&P 500 to reach its bottom after the initial rate cut. As the Fed anticipates three rate cuts in 2024, investors are grappling with the potential implications for the stock market.
As economic indicators align, investors are closely monitoring these warning signs, recognizing the challenges that may lie ahead in navigating the complex landscape of the stock market. The intersection of recession probabilities and monetary policy decisions creates an atmosphere of uncertainty, prompting market participants to stay vigilant and adjust their strategies accordingly.