Economic Forecast: Overcast, with a 30% Chance of Recession

Master Australian technical analyst Colin Twiggs highlighted the Wright Yield Curve Model in his monthly missives. The Wright Model expands on the theory that the slope of the yield curve is an accurate predictor of economic recessions by adding the level of the federal funds rate as an input.

According to Twiggs - the "probability of recession in the next four quarters increased to 31 per cent, according to the Wright Model (developed by Fed economist Jonathan H Wright)...a spike that reaches 50% would warn of a stronger down-turn."

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In Jonathan Wright's February 2006 paper in which he discusses his model, Wright concludes that "Currently, the yield curve is flat, not owing to a historically high level of the federal funds rate, but rather, to a low level of distant-horizon forward rates due in turn to some combination of low inflation expectations, low expected equilibrium real rates, and/or low term premiums." In other words, Wright's assessment at the time indicated that he did not believe a recession was likely. However, the federal funds rate has risen 50 basis points since February and 125 basis points since last year, when the paper was being written. I'm guessing that Wright is now assuming the probability of a recession are higher, as well.

Wright's probability jives with the Estrella and Mishkin model which just uses the level of the yield curve spread to establish the probability of a recession. The following chart comes from John Maudlin's "Thoughts From the Front Line" newsletter.

Currently, the spread between the 3 month Treasury and the ten-year Treasury is -0.29, according to the Bloomberg yield curve chart.

That spread puts the probability of a recession between 30% and 40% according to the Estrella and Mishkin model, which is right in line with the Wright model.

While a 30% chance of a recession isn't particularly high, I'm more worried about the current economic trends. Economic growth is definitely slowing. The housing market has hit a brick wall in many parts of the country that experienced a massive speculative bubble. And the unemployment rate could begin rising as the real estate market continues to slow. All this argues for lower long term interest rates, which would, in turn, result in a larger yield curve spread. And that would increase the probabilities for a recession, which would be a very worrisome development for the stock market.