From a small northwestern observatory…

The onset of a recession is much like the onset of a bad cold, or perhaps the flu.  You THINK you know you have it, and then the next morning you wake up feeling like you’ve been hit by a truck.

What if we had a tool that could actually PREDICT a recession a year or so in the future?  Wouldn’t that be handy?  In fact, two researchers at the New York Federal Reserve Bank actually developed something a few years ago (early 2006, to be precise) that seems to have some promise.  They noted that the spread between 10-year Treasuries and 3-month Treasuries was a leading indicators of economic activity (which makes intuitive sense).  Using historical data, they craft a formula which calculates the probability of a recession occurring in the coming 12 months:

…where “spread” is the difference, in percentage points, between the 10-year yield and the 3-month yield and F is the standard normal distribution (mean of 0, standard deviation of 1).  Plotting their data over time, and comparing to the onset of a recession, they get Chart 2.  While no model is 100% predictive, this one clearly indicates that a recession is highly probable whenever the spread-indicated probability gets much above 30%.

Of course, the statistical math can get a bit hairy, but there is a handy rule-of-thumb.  As you can see from Chart 1, whenever the spread turns negative, a recession is fairly likely in the coming months.  Why?  Because a negative spread suggests two things:  first, that borrowers have little demand for long-term money, and second that investors are looking for a safe place to tuck money away that they don’t think they’ll need for a while, and aren’t afraid of inflation.  In short, the yield spread constitutes a fairly accurate survey of investor expectations about the economy.

Unfortunately, Estrella and Trubin end their research with July, 2006, which at the time was giving off a 27% recession signal for July, 2007.  A great test of their model would be to see if it would have predicted the onset of the December, 2007, through March, 2009, recession.   We used the same H.15 data from the Federal Reserve Board, and came up with the following:

Ironically, our analysis shows that the probability of a recession crossed the 30% barrier on July 31, 2006 — a month after the cut-off of their study, and 16 months before the official “onset” of the recession.

By the way, if you’re worried, the current probability is at 1.8%.  We’ll keep you posted.