Recession Warning Tools

BarroMetrics Views: Recession Warning Tools

First off, thank you! Thanks to all those who took a moment to drop me a ‘get well’ note. It was very kind of you. My back is much better – still tender but at least the excruciating pain is gone. At least, I can sit! The anti-inflammatory pills, pain killers and ointment did their job.

Turning to today……..

…….. I’d like to look at:

  • Two tools that have served as advance warning signals of a recession to come; and
  • A new confirming tool.

The first is the St Louis FED, Adjusted Monetary Base.  The AMB shows the amount deposited by US banks in the Federal Reserve. At the moment, the FED is paying close to commercial rates. As a result, banks prefer to leave their funds with the FED rather than lending to Main Street – hence the lack of inflation. Once the AMB starts to trend down, we’ll be seeing money flowing into the economy. That will cause inflation to rise – based on FED history, faster than it will anticipate. It will then have to play catch-up with dramatic rate rises or face hyperinflation. Their catch-up leads to a recession.

Figure 1 shows the AMB. The signal I’m looking for is a breakdown that is followed by a strongly trending bear market. The bear trend will signal the release of funds to Main Street. As I said, that’s when we’ll see inflation rise and probably rise dramatically. There’s usually a 3 to 6-month lead time from the time the ABM figures to the time inflation is signalled by the CPI.

The next tool is the yield curve. In normal times, the longer-term maturities have a higher rate than the shorter ones. If the yield curve flattens and then inverts (long-term rates dip below short-term), we have a warning of a recession. I have attached a short piece by the FED that explains the indicator. (Figure 2)

Yesterday, FT ran an article suggesting the yield spread was sending an amber warning of a recession. Frankly, I think they are way ahead of themselves.

According to the FED, one of the most successful predictive yield models is the spread between the 3-month bills and 10-month notes. Figure 3 shows the spread. Yes, the spread is narrowing – the 10-year notes are ‘flat to down’, and the 3-month bills are ‘rising’. But, the current spread between the two is only 1.17 (St Louis Fed Reserve).

According to Attachment 2, with this spread, the probability of the yield curve correctly predicting a recession is less than 10%. That said, like the AMB, it’s an indicator I check regularly.

The final tool: one I was recently introduced to by Port Phillip Publishing. It’s the Baker Hughes Rigg Count of US oil and gas rigs.  Figure 4 is a chart of the BHRC with the recessions marked. Port Phillip says:

We have marked the years of US recessions…..We pay particular attention to the amount of time that has passed since the end of the last US recession — eight years. And the fact that the recessions seem to begin as the rig count is on the rise, rather than when it’s falling.”

My analysis of a chart of the BHRC and recession dates:

  1. This indicator lags the recession starts, and
  2. It serves as an excellent confirmation tool.

That said, oil prices are down 18% in 2017 and oil rigs are on the rise. The chart may be saying ‘get ready’.

So why am looking at recession indicators? Usually, the stock market tops before a recession. But within the current context (given the exuberance of the US stock market) we may well see a recession before the stock market tops.

FIGURE 1 Adjusted Monetary Base

(Chart through courtesy of  St Louis Fed Reserve)

2017-06-28 Yield Curve Predictor of Recessions FED

Attachment 2: FED explaining of Yield Curve

FIGURE 3 10-Year Notes cf 3-month Bills

(Chart through courtesy of  Quandl)

Figure 4 Baker Hughes Rigg Count

(Chart through courtesy of Bloomberg)

 

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