Another Take On Recession Risk And One Bank’s Look At Market “Stress”

If you’re looking for signs that the US economy will steer clear of recession, don’t look at the yield spread between 2-year and 10-year Treasurys:

As Bloomberg’s Tracy Alloway noted on Monday, the curve is getting “flat as a pancake,” and that’s not generally a good sign for the economy.

Bloomberg was referencing the latest weekly from Deutsche Bank’s credit team. For those who missed it, we brought you the highlights on Saturday here. According to the bank’s recession indicator (the implied probability based on 3M/10Y spreads), there’s a 60% chance the US is headed for a downturn.

As it turns out, Goldman doesn’t agree.

The bank has a model for just about everything, some of which are more accurate than others, but here’s what the “economic spillovers” indicator spit out when Goldman endeavored to quantify the effect of the UK referendum on a variety of economic variables outside the UK:

(Charts: Goldman)

So essentially, Brexit is meaningless for US GDP both near-term and medium-term and although they’ll be a bit of a disinflationary impulse through H1 2017, it will dissipate over time.

More broadly, Goldman looked at recession probabilities. At the risk of putting you to sleep, here’s the methodology:

“We estimate a so-called ‘probit’ model to explore the drivers of recession risk over these different horizons. Specifically, we regress the above ‘alarm’ indicators on (1) a country-specific ‘dummy’ to capture local average recession risk; (2) macro variables (including growth in year-over-year real GDP per capita and the IMF’s estimate of the output gap); (3) financial indicators (including recent changes in equity prices, house prices, and the exchange rate; and the 5-year change in the credit/GDP ratio); and (4) measures of uncertainty.”

“Exhibit 5 shows the estimated (or conditional) recession risks for Q3, the four quarters starting in Q3, and the eight quarters starting in Q3. We calculate the recession probabilities in the Euro area (EA) and in advanced economy (DM) as the GDP-weighted average of the country probabilities. 11. We compare the estimated risks with the unconditional probabilities of being in recession. For the US economy, for example, the unconditional probability of being in recession is 15% in any given quarter and as high as 34% over any given two years.”

Got that? No? That’s ok. Let’s just skip ahead to the charts:

(Charts: Goldman)

So what you’re looking at there is a country-by-country probability breakdown (left) and the incidence of actual recessions (defined by the NBER) and Goldman’s model probabilities.

The fit is pretty good.

Essentially, the bank says there’s about a 25% chance of a recession occurring sometime between now and Q2 2018. What’s amusing about that is you probably could have asked anyone who knows what the word “recession” means to estimate the probability of a downturn occurring in the next two years and they likely would have given you a similar answer even if they had no knowledge whatsoever about the current state of the economy.

Anyway, now that we have a post-Brexit snapshot of recession probabilities across the developed world, let’s look at what various capital and FX market indicators said about the extent to which the UK vote added stress to the system.

To gauge this, we can look at BofAML’s Global Financial Stress Index (they literally trademarked that, so don’t even think about creating your index and calling it the GFSI). Here’s a look at the subcomponents:

(Chart: BofAML)

Note the components highlighted in red. Let’s zoom in on cross-currency swaps and JPY implied vol. Here’s a snapshot so you can better visualize the stress level:

The increasingly negative swap spreads indicate a worsening dollar funding crunch. The last time Euro swap spreads were this negative, Draghi was giving his “whatever it takes speech.”

So what’s the takeaway? Here’s BofAML to summarize:

“The GFSI Risk Allocator favours being underweight risk assets given the distribution of stresses within the GFSI. Indeed the percentages of Bullish, Bearish and Neutral GFSI components (as used in the Risk Allocator) were 4.3%, 52.2% & 43.5%, respectively as of 24-Jun.”

So all things considered, it might be a good idea to take some off the table after last week. Of course then again, if you’d done that last Monday you’d have missed the boat entirely.

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