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Weekly eLetter 12/14/2018 – A Useful Recession Predictor

Last week we talked briefly about the inversion of a small part of the interest rate curve (specifically that the 5-year yield was higher than the 2-year yield by a few basis points.)  Lots of headlines. Today’s (Thursday) rate for both the 2- and 5-year treasury is 2.77%. We suggested that this is not the stuff recessions are made of – although they make for good eye-catching headlines.

So, if the 2 and 5 are not great predictors (in my opinion) what can we look for as an indication that we have a slowdown on our hands? Have a look at this handy chart, courtesy of First Trust (ftportfolios.com).

The chart shows a bit of history of two indicators. The Blue line is the Federal Funds Rate – loosely the rate that banks and similar institutions receive when they lend each other money overnight. You’ll note three rather outstanding peaks around 1970, 1974 and 1980. At these times the Fed Funds rates were very high. But high compared to what?

The orange line tracks the 2-year Annualized % change in Nominal GDP. Remember that the GDP numbers we more often hear about are ‘Real GDP’ numbers which are Nominal GDP plus Inflation. You’ll note that at each of these large peaks the Fed Funds Rate exceeded the GDP numbers. Not coincidentally, the peaks exceeding the GDP numbers also indicated the beginning of a recession. Read that again. These peaks also indicated the beginning of a recession. Point of interest – in 1979 and 1980 the Fed Funds Rate reached 20%!

And where are we today? Let’s have a look:

Today’s Fed Funds rate is about 2.25% and today’s annualized GDP rate is somewhere around 3.5%. Do the math. There’s still a rather large gap between the Fed Funds Rate and the GDP rate. Until the Fed Funds rate exceeds the GDP calculation, I am not concerned about an upcoming recession – at least not any time soon. Feel better now?

– Read more …