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Probability of Recession: In 12 Months vs. Within 12 Months

Summary:
With increasing term spreads (or, steepening of the yield curve), fears of imminent recession have waned. Does this make sense? In previous posts [1], I have been reporting estimates of a recession-month 12 months ahead, using probit models, estimated 1985 onward. Here, I use unadjusted 10yr-3mo spreads as well as adjusted by estimated term premium, 1967-onward. But what might be of greater interest is whether a recession will start any time within the next twelve months. In order to assess this, I estimate two probit regressions, 1967-2019M11. First, the conventional specification. Prob(recessiont+12) = -0.245 – 0.752 spreadt + ut+12 McFadden R2 = 0.31, NObs = 623. Coefficients significant at 5% msl bold. The spread is in percentage points. Next, the specification for recession any time

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With increasing term spreads (or, steepening of the yield curve), fears of imminent recession have waned. Does this make sense?

In previous posts [1], I have been reporting estimates of a recession-month 12 months ahead, using probit models, estimated 1985 onward. Here, I use unadjusted 10yr-3mo spreads as well as adjusted by estimated term premium, 1967-onward. But what might be of greater interest is whether a recession will start any time within the next twelve months.

In order to assess this, I estimate two probit regressions, 1967-2019M11. First, the conventional specification.

Prob(recessiont+12) = -0.245 – 0.752 spreadt + ut+12

McFadden R2 = 0.31, NObs = 623. Coefficients significant at 5% msl bold. The spread is in percentage points.

Next, the specification for recession any time within the next twelve months

Prob(recessiont,t+12) = 0.266 – 0.595 spreadt + ut+12

McFadden R2 = 0.21, NObs = 623. Coefficients significant at 5% msl bold. The spread is in percentage points.

The resulting recession probabilities are shown in Figure 1.

Probability of Recession: In 12 Months vs. Within 12 Months

Figure 1: Estimated probability of recession within 12 months up to indicated date (blue), and in indicated month (red). NBER recession shaded gray. Light green shading denotes forecast period. Source: NBER and author’s calculations.

These estimates based on the 10yr-3mo spread (3 month is Treasury bill secondary market).

Probability of Recession: In 12 Months vs. Within 12 Months

Figure 2: Ten year-three month Treasury spread, % (black). NBER defined recession dates shaded gray. Light green shading denotes forecast period. Source: Federal Reserve via FRED, and NBER.

While the estimated probability of recession in November 2020 is 33%, down from 50% for August 2020, the estimated probability of a recession within the next twelve months is fairly high, at 54%.

So, too early to relax…

Addendum:

I should give proper credit to where I got the idea to try to estimate the cumulative probability; it’s from Johansson, Meldrum, “Predicting Recession Probabilities Using the Slope of the Yield Curve,” FEDS Notes, March 2018.

Menzie Chinn
He is Professor of Public Affairs and Economics at the University of Wisconsin, Madison

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