The Odds of a US Recession Within a Year Are Now 1 in 2

We have updated our recession predictor models with the latest financial data. The main points worth noting are as follows:

1. The pure bond market-based models’ probabilities are still declining, in line with the ongoing Fed easing policy.
2. On the other hand, our preferred model, Model 10 (which accounts for credit and equity markets conditions, in addition to bond markets), is assessing the chances of a recession as being roughly one in two within the coming year (the figure is 48%). Model 1 and Model 10 have converged.
3. The main drivers of this increase in recession risk were: (i) A fall in equity market performance (from nearly +13%Y in October to +5%Y in November). (ii) The Sr. Loan Officer Survey suggests tightening credit conditions going into year-end. (iii) A drying up of the commercial paper outstanding market (-3.4%Y). (iv) The credit spread widened further, although only marginally.
4. These developments have more than compensated for the decrease in FFR and 3m-10y spread, so that the overall risk of recession has increased considerably. In other words, the current Fed easing and the associated lower perceived risk of recession in bond markets (alone) were not enough to decrease the overall perceived risk of recession when accounting for equity and credit market developments.
5. A Fed cut to 4.25% is expected by our US economists this month. All things being equal, this would lower the probability of our preferred model to 42%. If furthermore the yield spread narrows by the same amount, this probability would be 33% (back to October levels). However, if we suppose that credit conditions deteriorate slightly and that the current S&P futures contract for end-December is reached (both arguably incorporate future expected Fed cut(s)), the model probability would remain broadly unchanged from its current level. Everything else being equal, a 25bp Fed rate cut would ‘offset’ a 1% decline in the S&P or an 8% rise in the credit spread.

By Stephen Jen & Luca Bindelli London
Morgan Stanley
December 7, 2007