The S&P 500 (SPY) has dropped more than 5% and the DJIA (DIA) has dropped 6.9% from the peak. The recent market pullback has rekindled the fears about another recession. Are we heading for a recession now? I think that the recession is very unlikely to occur in 2014. Here are the reasons.
- The Federal Reserve is in driver seat. With the taper notwithstanding, the leading predictor of recession is the yield curve spread between 10-Year and 2-Year treasury rates (red line in figure 1). If the spread goes below zero, the recession invariably follows in a quarter or two. At the moment the spread is close to 2.5%. The spread between 10-year treasury and Fed funds rate (blue line) is also shown for comparison. This spread is a bit volatile.
Figure 1: Red line: 10 year - 2 year treasury rates, Blue line: 10-Year treasury - fed funds rate. The shaded areas in the graph are the recessions.
- The leading economic index is above the trend line of 400. In the last three recessions, the index dipped below 400 and eventually below 0 during the recession. The index stands closer to 700 now.
- The real retail and food service sales flattens (stops growing) when nearing a recession. The current trend is an upward slope.
- The yield curve is upward sloping. In most of the recessions, the yield curve inverts.
The current yield curve is compared with the S&P 500 peaks of last two recessions.
S&P Aug-2000 peak:
S&P peak Oct-2007
- The percentage change in employees involved in truck transportation is positive. In the last two recessions, the percentage change dipped below zero.
- The last but not the least, the smoothed recession probability is trending at 0.1%.
The chances of a recession are very low as long, as the effects of tapering are more than offset by the improvement in economy. The Federal Reserve actively monitors the economy and would slow down the taper at the first hint of slow down in the economy. The Fed is unlikely to increase the key interest rates without seeing signs of improvements in unemployment rate. The central bank in its statement says that it will probably hold its target interest rate near zero "at least as long as" unemployment exceeds 6.5%, so long as the outlook for inflation is no higher than 2.5%. The unemployment today stands at 7.3%; we've a long way to go before we see an increase in key interest rates. The best metric to watch out for the recession is the yield spread.