Financial Shock Indicator - Recession Prediction Tool

30 Okt 2019

I've been looking around for various data tools to indicate recessions catalysts and their relationships to financial indicators over the past few months. From those efforts, I've honed in on a particularly interesting ratio that seems to indicate financial shocks that spark recessions (indicated with green shading). It looks like when you take the Fed's Interest Rate (FEDFUNDS) and divide that by the spread of the 10Y (TYX) and 5Y (FVX) treasury bond you get inverted peaks that mark times when a severe financial shock has been applied to the US economy. The delineating factor on if it will truly trigger a recession or not, I think, hinges on the nature of the disruption.

You can see with the Clinton Impeachment, there wasn't a resulting recession. There were issues present the caused the fed to cut rates during those times, but apparently the cause wasn't significant enough (Asian and Russian Financial Crisis). So, I ask myself, is Trump's Tariff War significant enough of a shock to trigger a recession? The Q3 GDP doesn't seem to indicate it, but a look back at the 2000 bubble shows a similar trend. Trump's Tax Cut (giving a boost to the GDP in a low sales time period) may be insulating the US economy from a true recession, but it's not clear.

There may be a better data set to plot this out further, which I'll be working on, to see how it aligns with more than the previous 2 recessions but I wanted to get this out there for people to weigh and challenge. My other comment regarding applicability is that Cam Harvey's inverted yield curve can be set up with a variety of combinations. In the Duke article published in July of 2019, Harvey himself describes the recession indicating inverted yield curve as the difference between the 10 year and 3 month treasury bill in an inverted state for an entire quarter. That event did not occur in 1998. So, the combination of the Financial Shock Indicator with a preceding inverted 10yr-3m yield curve for more than a quarter gives you a 100% chance of recession (from an n=2).

Either way, I think my Financial Shock Indicator, when used with the inverted yield curve, may be indicative of true recession predictions. But we'll see how it turns out.

3 Mac 2020

Nota

The Coronavirus has initiated another financial shock and lead to the inversion of the 10y 3m yield curve. This even seems more severe than the previously observed tariff shock.

With the independence of viral transmission and interest rates controlled by the central banks, this may well be the trigger to recession the inverted curve predicted. Moreover, this recession will not be dependent on fiscal policy around the globe, but rather the ability of workers to survive the virus and return to work without decimating the remaining healthy workforce.

As before, we'll see how this turns out, but it does look like the indicator measures severe hits to the US economy.