Recession Probability Rising

The chances of a recession taking place within the next 12 months is rising. 

At the beginning of 2005, the probability of a recession was very low.  Over the course of this year, and especially in the last 5 months, the probability has risen steadily.  According to the one model, the current probability of a recession in the next 12 months is approaching 20%.

The rise in the risk of a recession is due in large part to the flattening of the yield curve and rising energy costs.  A flat or inverted yield curve is well documented as a leading indicator of  GDP growth.  Each U.S. recession since 1950 has been preceded by an inverted yield curve.  For a review of the literature, see Zeno Rotondi's The Macroeconomy and the Yield Curve: A Review of the Literature with Some New Evidence .  For a detailed analysis see What Does the Yield Curve Tell Us about GDP Growth? by Andrew Ang, Monika Piazzessi and Min Wei.

Also, Stockcharts.com has an interesting tool where you can see the S&P 500 Index and see what the yield curve looked like at that time.  Scroll back to late 2000 to see an inverted yield curve.

The Financial Methods model incorporates the yield curve, energy prices, monetary policy, and other factors to generate the estimated probability of a recession taking place in the next 12 months.  With the Fed determined to continue raising short rates, this probability may continue to rise.   

Even though the recession probability rose further in August, the yield curve has steepened slightly since we last discussed it.  The 10-yr to 2-year bond spread has increased from 18 basis points to 54 as of Friday September 2.   

Although a 20% chance of recession is a new high for the year, the bright side of this picture is that we have an 80% chance of continued expansion.