Foreign term spreads in several major financial centers have inverted (you can see the yield curves here). What is the probability of a recession 12 months ahead, using the 10yr-3mo term spread, the foreign (Germany, UK, Japan, Canada) 10yr-3mo term spread, and the National Financial Conditions Index (FCI), as suggested by Ahmed and Chinn (2022)? Answer: High

Using these variables, and forecasting recession in 12 months (not within 12 months), we find the following:

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Figure 1: Forecasted probability of recession from 10yr-3mo term spread (blue), from 10yr-3mo term spread augmented with FCI (red), 10yr-3mo term spread augmented by FCIand foreign term spread (sky blue). All models estimated over 1986M01-2023M01, except foreign term spread augmented, 1989M04-2023M01. January observation for FCI thru 1/27; foreign term spreads as of 1/31/2023. NBER defined peak-to-trough recession dates shaded gray. Red dashed line at 50% probability. Source: NBER, and author’s calculations.

These estimates all pass the 50% threshold by November 2023 (October 2023 for the plain vanilla term spread model). The FCI augmented specifications also predict a recession month in 2009M12, but this seems to be an artifact driven by the inclusion of the FCI, which spikes year earlier (2008M11). (Also, changing the specification to “within next 12 months” instead of “at 12 months ahead removes this spike).

Here are the spreads and the Chicago National Financial Conditions Index.

(Click on image to enlarge)

Figure 2: US 10yr-3mo term spread (blue, left scale), foreign 10yr-3mo term spread augmented (sky blue, left scale), both in %, and national FCI (red, right scale). January observation for FCI thru 1/27; foreign term spreads as of 1/31/2023. NBER defined peak-to-trough recession dates shaded gray. Source: Treasury via FRED, Chicago Fed, OECD, NBER, and author’s calculations.

Interestingly, the WSJ October 2022 survey of economists pegged the probability of recession at 49%; that rose to 63% in its January survey. (See a comparison of 3m10s probit model and WSJ probabilities here).

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