NY Federal Reserve’s Recession Indicator 2012-06-01 to 2012-06-30

Summary:
The New York Fed's leading indication put the probability of a recession one year from now at 6.66% in June, marking the third consecutive month of a worsening conditions. However, with the Fed's current policies--such as keeping short-term rates near zero and "Operation Twist"--this figure is once again mostly manufactured, and likely does not accurately reflect market conditions. Therefore, we monitor this figure with a cautious eye.

Extended Analysis:
Actions by the Federal Reserve in three meetings of the Board of Governors during June resulted in driving interest once again for the month. Results included a downward revision of several U.S. economic indicators, such as employment and Gross Domestic Product (GDP). The Fed announced that it expects the nation’s unemployment rate—currently sitting at a historically high 8.2%¬—to remain relatively unchanged for the remainder of 2012. Also, the Board’s new forecast for GDP growth is 1.9-2.4% for this year, which is about half a percent lower than April’s expectation. In light of this news, the U.S. central bank will continue its ongoing program called “Operation Twist.” This policy of exchanging treasuries of short-term maturity for longer-term scheduled to end in June has been ongoing since September 2011, and has so far resulted in $400 billion in exchanged bonds. Such an increase in the demand for 10-year Treasury Notes has successfully forced down yields from around 3% last summer to 1.62% this month, and now, as part of Operation Twist’s extension the Fed plans to trade in an additional $267 billion.

The Fed’s extension of Operation Twist a hopeful effort to spur economic growth and spending, as lower interest rates generally mean more business and consumer borrowing. In fact, this policy has not only pushed down rates on Treasuries, but on corporate bonds as well, which allows mostly large-capitalization businesses to borrow at cheaper rates—since the size of a loan must be substantial to justify the cost that goes along with issuing bonds. For example, an investment bank must be hired to handle the issuance and set appropriate coupon rates. Operation Twist has also led to lower lending rates from banks, but most still have incredibly high underwriting standards. Therefore, it seems likely that yields on both 10-year Treasuries and AAA-rated bonds will continue to decline, but until the economy shows signs of stronger growth the spread will rise. Moreover, yields on short-term Treasuries (such as the 3-month) remain bottomed out at very close to zero, and may even raise slightly as Operation Twist increases the supply. Therefore, we feel that the New York Fed’s recession predictor from the yield curve will also continue to rise.