Recession Risk – Easy Pod (Apr 5, 2012)

Recession is a scary word for most, and rightfully so.  Let’s talk about it.  I’m continuing a feature called “Easy Pod” – a collection of economic indicators that help portray the current status of something.  In this post, that something is the risk that the U.S. economy will enter a recession in the near future.

(This next section is my usual intro to what a recession is – you can skip straight to below the first line to start reading the actual content.)

Surely you’ve heard the word recession thrown around in many of the discussions you’ve read about the economy.  Let’s first review quickly what a recession is and why it matters.

From Merriam-Webster Dictionary:

Recession = a period of reduced economic activity

The most commonly accepted way of measuring economic activity is to examine Gross Domestic Product (GDP).  I discussed what the GDP is in this post.  But a very quick review is that the GDP attempts to measure the total value of all economic activity.  Anything someone is willing to pay for would typically go into GDP.  So, it’s no surprise that one of the easiest ways to define a recession would involve a GDP that goes down.

Many people define a recession as “two consecutive quarters of declining GDP.”  That’s six months of an economy that is basically shrinking.  That’s the quick and dirty method.  But the “official” determination of when the U.S. economy is in recession comes from a group called the National Bureau of Economic Research (NBER).  These folks take a look at all kinds of data, not just GDP.  And they make the determination of when the economy is contracting or expanding.  They often make these determinations many months or perhaps years after the fact.  But it’s considered a more accurate assessment than the simple rule of two quarters of declining GDP.

Why do recessions matter?  Well, you could argue that technically it doesn’t matter whether the economy is growing at 0.001% rate or contracting at a -0.001% rate.  Those two are virtually identical, yet the former could conceivably be the determining factor for being in a recession versus not.  I think the basic idea here is that we want our economy to grow.  It has to grow to support the growing population.  New people need new jobs and new houses.  We can’t have those things if the economy is shrinking.  And while the normal cycles of the economy can lead to brief, temporary periods of contraction (shrinking), we want to avoid prolonged ones.  Thus, the term “recession” refers to a more significant period of contraction.

Determining whether we are in a recession now or that we were in a recession previously is all fine and dandy, but what people like you and me really want to know is whether we are going to be in a recession in the near future.  And for that, there are some helpful tools.  In this “Easy Pod” I will take a look at a few different estimates of the risk of the U.S. economy entering a recession.

For a quick read of this post, just read all the sections highlighted in yellow, plus review the labeled white boxes, and finish off with the “Easy Take” conclusion.

Method #1: Yield Spreads, Credit Spreads and Other Spreads

Basic Concept: U.S. Treasuries (loans people make to the U.S. Government so it can fund its operations) are considered the safest investment, essentially risk free.  That means you usually get some of the lowest interest paid to you (yield) on these investments – remember, less risk equals less reward.  If you compare the interest rate on other kinds of loans, like corporate bonds (loans that people make to companies so they can fund their operations), to the interest rate of Treasuries, you can get a sense for how risky the other investment really is.  That difference in interest rates is called a “spread.”  Similarly, if you look at the yield on a longer-term Treasury versus a shorter-term one, you can see how much riskier the longer-term loan really is.

Federal Reserve Bank of New York

One of the reasonably good predictors for recessions has been the difference between the yield on 10-year Treasury notes and 3-month Treasury bills.  Generally speaking, when you lend someone money for a longer period of time, you expect to be paid interest at a higher rate, because there are greater risks that the money will not be returned to you, and you likely had other great things you could have done with that money.  Thus, it makes sense that the yield on 10-year Treasuries should be higher than 3-month Treasuries.  But how much more is a pretty good indicator for what is coming up in the economy.

When times are starting to get tough, people start worrying even about short-term loans to the government, and so the difference between these two yields gets less and less.  If it flip-flops and the yield is higher on 3-month than on 10-year, it’s a really good bet that a recession is around the corner (probably 9 months or so later).

The Federal Reserve Bank of New York translates the “spread” (difference) between the 10-year and 3-month Treasury into a probability of recession in the upcoming 12 months.

According to the Federal Reserve Bank of New York, the probability that the U.S. economy will be in recession in February 2013 is only 4.24% – up from a 3.80% chance of recession in December 2012.

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