NY Federal Reserve’s Recession Indicator 2012-05-01 to 2012-05-31

Summary:
The New York Fed's recession indicator showed the probability of a recession in the U.S. one year from now as 5.28% in May, representing an increase of 1.53 percentage points from April. This also represents an increase of 4.69 percentage points from May 2011, as the probability of a recession was less than 1% a year ago. May's increase was caused by a declining yield curve, which came almost entirely from a decrease in the yield on ten-year Treasuries.

Extended Analysis:
Although there are many theories as to why the yield curve—or the spread between the yields of ten-year and three-month Treasuries—has a strong correlation with future recessions, there is no definitive answer. Particularly, an inverted yield curve can nearly guarantee a recession, historically speaking. We say the yield curve becomes inverted when current rates on ten-year Treasuries is lower than current rates on three-month Treasuries. However, all theories regarding this phenomenon indicate that it has something to do with market expectations, and therefore relies on free-market supply and demand. Although we have previously mentioned that demand for three-month Treasuries is currently being manufactured by the Federal Reserve’s open-market operations, the ongoing "Operation Twist” is currently doing the same thing to yields on ten-year Treasuries.

“Operation Twist” is a double entendre from the 1960 Chubby Checker song––because the Federal Reserve tried a similar policy back in the 60’s––and the effect it has on the yield curve—essentially “twisting” it. The current policy entails selling shorter-term Treasuries (say, with a maturity of two or three years) and using the proceeds to purchase longer-term Treasuries, like ten-year. Clearly, this does not increase the money supply—as the two rounds of quantitative easing did—but it does increase demand for ten-year Treasuries, which drives down yields. On the other hand, the European debt-crisis and poor employment data in the U.S. likely added to the demand for ten-year Treasuries in May, and so drove down ten-year yields to unprecedented lows. In fact, this also explains the historically low yields on triple-A rated U.S. bonds, as few were interested in European bonds or U.S. stocks in May. Notice how this ties together with other indicators: all major stock indexes were down in that month, oil declined on falling global industrial demand, and initial unemployment claims were on the rise. The Eurozone was especially nerve-racking, as the French elected a socialist president who seemed likely to butt heads with Germany, Greek elections showed no definitive results and left uncertainty as to whether they would remain on the euro, and yields on Spanish sovereign debt rose to unsustainable levels.

Since “Operation Twist” will last at least through June—some think it will be extended—it is safe to say that yields will remain low for the ten-year. This is due to the fact that the Fed has purchased about $99 billion in 8-10 year Treasuries under the “Twist” program, while at the same time around $153 billion of ten-year notes have been issued; hence the Fed is soaking up about two-thirds of the new supply right now. Favorable news from the Eurozone or a boost in certain nations’ economies (particularly the U.S., and perhaps China) may offset Fed policies. Such news would certainly send AAA-rated bond yields higher. Three-month Treasuries, however, are very unlikely to increase on such short notice. Therefore, we see both the NY Fed’s recession probability and the credit spread increasing in June—perhaps to around 6% and 2.05%, respectively—but we maintain our position that this does not give much insight of the future.