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From an article today on Investopedia: Bonds Signal up to 60% Chance of Recession

Earlier in 2019, the Federal Reserve announced a pause in its program of interest rate hikes, re-energizing the stock market in the process. Now the money market appears to be anticipating a cut in the federal funds rate before 2019 is over, which, in turn, suggests that the Fed is increasingly more worried about preventing a recession than combatting inflation. Deutsche Bank projects that the fed funds rate will end 2019 at 2.15%, implying a 60% chance of recession within the next 12 months, Barron's reports.

INDICATORS OF INCREASED RECESSIONARY RISK

  • The Fed now seems more concerned with recession than inflation
  • The money market anticipates a federal funds rate cut in 2019
  • This implies 60% odds of a recession starting in the next 12 months
  • Longer-term yields imply 28% odds of recession with next 12 months

How did they calculate the odds of a recession from the fed fund rates?

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    That article assumes that there aren't other external factors affecting the Fed's decision to not raise rates... (Like when the "boss" publicly encourages the fed chairperson not to raise rates.) – TTT May 22 at 19:04
  • My question isn't about what affects the fed's decision to raise or lower rates but how are they determining the probability of a recession from the fed funds rate. Do you have any suggestions regarding that? – Bob Baerker May 22 at 20:00
  • But what affects the fed's decision is extremely important. Suppose the fed flipped a coin to decide raise it or leave it. If you knew that, concluding anything based on the decision would be wrong. Now suppose the fed was going to raise rates again, but held back so they don't lose their job. If that happened, then concluding they didn't raise rates due to a potential recession coming would also be wrong. The fact that the article didn't mention any external factors leads me to believe they may not have considered them in their calculation, so it could very well be way off. – TTT May 22 at 20:07
  • I am abstaining from a vote here. It feels like PF to me, understanding data that we use to make a decision. – JTP - Apologise to Monica May 22 at 22:00
  • Joe: Fed fund rates and a potential recession is very much a factor in how one invests as well as how one might adjust one's portfolio and is indeed a Personal Finance decision. – Bob Baerker May 22 at 22:09
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Calculating the odds of a recession based on the fed funds rate most likely used a dartboard. Or maybe some colorful dice.

I kid. Most likely it was a computational model, which is totally different from dartboards or dice because people won't pay institutional research firms who claim to use methods that are transparently easy to understand to try to predict macroeconomic market timing.

So I want to be clear - what you are reading is a sales pitch for Deutsche Bank, which is a sales pitch provided by Deutsche Bank Research, wrapped inside a sales pitch for Ned Davis Research, wrapped inside a sales pitch for Barron's, delivered as a sales pitch for Investopedia's blog.

It does not say how they calculate such a probability, because that is what Deutsche Bank would like you to pay them for. They have teams of highly educated, highly skilled, highly experienced analysts (who I'm sure are wonderful people) churning out weighted random numbers like this - they can't just give away the secret sauce!

But at a high level, I can tell you how they calculated it:

First you build a statistical model that takes certain variables and assumes or attempts to estimate certain relationships between the variables, which will likely include the fed rate and dozens, hundreds, or thousands of other variables. Then you take some source of data about market performance and fed rates, pulled from somewhere (probably bought it from a vendor, but maybe provided by an internal team). But you can't just put that in the model as-is, so you make a variety of ultimately arbitrary decisions on how to process the data, so you do that and feed it to the model. The model puts out tons of outputs, but no single number, so you have to either cherry pick out what number is interesting or try to shove all the numbers together somehow. If you do a good job you have a number of competing models and processes, but that only means you have even more numbers coming out the other side, so you have to cherry pick one or shove them together again.

The reporting team, or someone's boss, wants a number, such as the chance of the market going into recession in the next 12 months. They don't want a distribution, they don't want a confidence interval, they don't want to hear about your assumptions or your process or any of your mumbo jumbo about information theoretic predictive accuracy, pareto efficiency of estimators, or your concern about autocorrelation in the Kullback–Leibler divergence of the residuals - they want a damned number to put in the sales report, alright?

Fine, 60%.

It's a nice number, no one is going to say you are insane for making it so high, and they won't say you are a Pollyanna who thinks a recession can't happen because it is so low. It also isn't 50%, because if you said that people would point out that's just saying bear vs bull is the result of a coin-flip! What are you, some kind of amateur?

Yeah, 60%. Now that's a number we can work with. But wait, why did we come up with this number? Don't tell me about all the variables you included in the model, so help me if you try to say something about "polynomial" or "multivariate" I'll slap the...right, bonds, let's go with that. Bonds are signalling, there we go - wrap that up and you've got a nice headline!

Bottom-line: news fit only to line the bottom of bird cages. It has no real informational content. Timing the market has long proven to be a fools errand - badly reported, non-transparent, baloney statistics don't change that.

  • Thanks for an answer with substance as well as some tongue in cheek comments :->) – Bob Baerker May 24 at 2:42

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