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Economic Research: U.S. Business Cycle Barometer: Recession Risk Still Elevated Amid Uncertain Growth Prospects


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Economic Research: U.S. Business Cycle Barometer: Recession Risk Still Elevated Amid Uncertain Growth Prospects

S&P Global Ratings Economics' recession model implies the probability of a recession starting within the next 12 months is 30%-35% (see chart 1). Our model is based on key forward-looking financial market indicators and the Organization for Economic Co-operation and Development's leading economic index through August. While the probability of a recession has eased since spring, it remains elevated.

Chart 1


The Yield Curve Throws A Red Flag

The primary factor in the evolution of recession probability in our model is the yield curve. The spread between yields of 10-year and three-month Treasuries has been inverted since October of last year in this expansion (see chart 2). In May, the long end started to rise, thus reducing some of the inversion's depth. Since mid-May, 75% of the 80-basis-point rise has stemmed from a rise in real interest rates, and the other 25% owes to a boost in inflation expectations.

An inverted yield curve (in the U.S., though not necessarily other advanced countries) has predicted seven of the past seven recessions, with no false positives (unlike the stock market, which is well known for its false positives). A few times when the yield spread came close to inverting (for example, in 1995 and 1998), the Federal Reserve responded by preemptively cutting rates, which in hindsight appears to have helped extend the expansion. Historically, the time between the first month of an inversion and the start of a recession has ranged from six to 18 months.

Chart 2


The explanations for such tight correlation vary from financial market participants' expectations for central bank policy (linked to expectations of business cycle outcomes) to market attitudes toward various risks (also influenced by economic outcomes). Still, at its core, the current yield curve inversion primarily reflects that investors expect the Fed will eventually have to cut interest rates, which in turn may i) reflect the view that the Fed will go too far and push the economy into recession, or ii) simply reflect that the Fed has pushed the policy rate above its expected long-run average and that its success in bringing down inflation will allow it to later reverse course. We think the latter may be the case.

Besides, it may also be the case that yield curves are now more susceptible to inversions, given long-term natural interest rates have trended down in the past 40 years to under 1%. Over the years, as the Fed has become more transparent and large-scale asset purchases (quantitative easing) have become part of the norm, term premium on 10-year bond yields has become structurally low, which has also made yield spreads susceptible to inversions.

All told, while our econometric model suggests a 31.5% risk of a recession, down from spring, we remain wary considering it was flashing near 50-50 odds in May. Our dashboard of leading indicators is not quite indicating that the coast is clear, and coincident indicators are either in a late cycle or approaching one. Although our baseline economic forecast avoids recession in the next 12 months, the balance of risks is clearly tilted to the downside.

Mixed Signals On Momentum

Data for the second and third quarters so far demonstrates economic resilience, with growth surprising to the upside. The running estimate of real GDP growth for the third quarter is near 4%, an acceleration from the first half's 2.1% average.

Still, our dashboard of 10 principal forward-looking indicators gives mixed signals on near-term economic growth prospects (see below). As of August, four of the indicators were flashing negative signals on growth momentum, while the other six were neutral or positive. August data on the Freight Transportation Services Index is pending as of Sept. 20 {see the appendix for our rules on signal transition).


Elements reflecting expectations were split. The inverted term spread and equity market flashed negative in August as the S&P 500 index gyrated down from the high of 4589 on Aug. 1. On the other hand, the other leading indicator from the capital markets, the credit spread, turned positive last month, with both investment-grade and speculative-grade corporate credit spreads tightening further during the summer (see chart 3).

Chart 3


Consumer sentiment

The Consumer Sentiment Index from the University of Michigan rose again in August before inching down in the first half of September (see chart 4). The three-month moving average of this index also moved higher.

Chart 4


That said, we also look at the Conference Board's Consumer Confidence Index. The Conference Board's expectations index--based on consumers' short-term outlook for income, business, and labor market conditions--in August was barely above 80, the level that historically signals a recession within the next year.

Gas prices have also risen again since August, and that's surely going to erode some optimism. Taking these factors together, we think consumer are likely to become more careful with their wallets.

Job market

All the while, layoffs--as indicated by initial jobless claims--remain near historical lows. That said, hiring of temporary help services (a lesser-known leading indicator) has started to decline, which indicates that the pace of payroll job gains is likely to continue softening in the coming months (see charts 5 and 6).

Chart 5


Chart 6



The Institute of Supply Management Manufacturing New Orders Index stayed below 50 in August, reflecting continued headwinds to growth from the manufacturing sector (see chart 7). Sentiment in the manufacturing sector turned sour 12 months ago and has yet to reverse. That said, a New Orders Index below 52.5 over time is generally consistent with a decrease in the Census Bureau's series on manufacturing orders.

On the other hand, Manufacturers New Orders: Nondefense Excluding Aircrafts has been moving up year to date (see chart 8). The Freight Transportation Services Index (data is pending for August), covering all domestic transport of commercial freight, turned neutral (from negative) in July.

Chart 7


Chart 8



Meanwhile, the housing sector appears to have found a floor. Single-family starts and, more important, permits (which offer a way to track future construction) have bounced up from January lows and revealed a grinding-up pattern in the past few months (see chart 9). Nonetheless, high interest rates will limit the positive impulse to growth in the housing market.

Chart 9


Bank lending and financial conditions

Banks are continuing to tighten lending standards across the board (see chart 10). Loan officers believe high inflation and interest rates are working to lower borrowers' debt servicing capacity, increasing their exposure to risk. Demand has continued to weaken across loan categories.

For the second half of 2023, banks have reported expecting to further tighten standards on all loan categories. They most frequently cited a less favorable or more uncertain economic outlook, as well as expected deterioration in collateral values and the credit quality of loans, as reasons for expecting to tighten lending standards.

Meanwhile, the Chicago Fed's National Financial Conditions Index (NFCI), which is a composite measure used to sense stress in the financial system, remains a tad below zero (even as the leverage subcomponent is elevated), which we consider neutral for growth. A zero value for the NFCI can be thought of as the U.S. financial system operating at a historically average level of risk, credit, and leverage (see chart 11).

Chart 10


Chart 11


While broader financial conditions' negative impulse on growth has eased since the banking sector turmoil in March--when three major U.S. banks failed and a global systemically important bank, Credit Suisse, failed for the first time since the global financial crisis--it remains significant historically (see chart 12).

Chart 12


Little Room For Cyclical Expansion

Broadly, the economy has little room for cyclical expansion. The output gap is positive (see chart 13), and the labor market is at full employment (see chart 14).

Chart 13


Chart 14


In August 2023, nonfarm payrolls outperformed expectations with a gain of 187,000 jobs, showcasing a resilient labor market, but the pace of growth has moderated (see chart 15). Furthermore, the employment-to-population ratio of prime-age workers (25-54)--a demographic unaffected by voluntary retirement--reached 80.9%, its highest since 2001 (see chart 16).

Chart 15


Chart 16


Meanwhile, industry capacity utilization has shown notable resilience in recent quarters, as evidenced by the marginal uptick to 79.7 in August 2023 (see chart 17), near the long-term average (1968-2022). Manufacturers' inventory stock is high relative to sales on a historical basis, while retailers are keeping it lean (see chart 18).

The total business inventory-to-sales ratio (for wholesalers) remained at 1.39 at the end of July 2023--a very high mark. A higher ratio implies a prolonged inventory turnover period, which may reflect reduced demand, often associated with a slowdown in economic activity.

Chart 17


Chart 18



Key business cycle statistics
--Real GDP-- --Unemployment rate-- Deviation from natural rate of unemployment rate Inflation Fed funds rate
BCB pub Peak to peak (%) Peak to trough (%) Trough to peak (%) Lowest value of cycle (%) Highest value of cycle (%) Unemployment rate - NAIRU (ppt) Value at peak GDP (%) Value at peak GDP (%)
1948 - 1953 27.3 (1.7) 30.3 2.5 7.9 (2.8) 0.9
1953 - 1957 10.9 (2.5) 13.2 2.7 6.1 (1.2) 3.5 3.2
1957 - 1960 8.6 (3.6) 9.8 4.4 7.5 (0.4) 2.1 3.9
1960 - 1969 51.7 (1.3) 53.7 3.4 7.1 (2.3) 4.7 9.0
1970 - 1973 14.8 (0.2) 16.1 3.9 6.1 (1.3) 4.9 10.0
1974 - 1980 20.1 (3.1) 21.7 4.9 9.0 0.1 8.9 15.1
1980 - 1990 37.5 (2.1) 40.5 5.0 10.8 0.0 4.3 8.2
1990 - 2001 41.4 (1.3) 42.7 3.8 7.8 (0.8) 2.0 4.3
2001 - 2007 18.5 (0.4) 19.3 4.3 6.3 (0.1) 2.3 4.5
2008 - 2020 20.2 (3.8) 23.6 3.5 10.0 (0.7) 1.7 1.3
2020 - Q2 2023 7.4 (1.2) 17.4 3.4 14.7 (0.8) 4.4 5.0
Notes: Peak to trough to peak makes a business cycle. Inflation periods (1948-1953, 1953-1957) represented by consumer price index while rest are represented by core-PCE. NAIRU as estimated by the Congressional Budget Office. Unemployment rate shows the lowest and highest values during the particular periods. Inflation and Fed funds rate show the highest values corresponding to the peak GDP values attained during that particular period.
Definitions of positive/neutral/negative signals
  • Positive: Overall economic activity will continue to expand in the near term, without an obvious slowdown.
  • Neutral: Overall economic activity will continue to expand but may be slower. Right after a recession, a neutral signal indicates that the recovery may have just started.
  • Negative: Overall economic activities will start to contract shortly afterward, roughly within a year.

The signals refer to the near-term growth perspectives suggested by the changes in a certain leading indicator during the past three months (since our previous publication). To determine whether the changes have been statistically significant (at a 5% significance level) to change the signal, we carry out a simple t-test against the historical sample. To capture the expansion and recession periods of business cycles without bias, we select the series between December 1982 and June 2009 as the historical representation, which includes three complete business cycles. For shorter series, we use the entire series until the end of 2017. Note that a negative growth signal is not equivalent to a recession in the near term.

Growth signal decision rules
Indicator Decision Rule Sample
Term spread Negative: less than 0 1/1/1978 – 8/1/2023
Neutral: 0 to 40th percentile
Positive: above 40th percentile
Credit spread Recession in the past 12 months: 1/1/1997 – 8/1/2023
Negative: above 90th
Neutral: 75th to 90th
Positive: less than 75th
Recession NOT in the past 12 months:
Negative: above 75th
Neutral: 40th to 75th
Positive: less than 40th
S&P 500 Negative signal in the past 6 months: 1/1/1978 – 8/1/2023
Negative: below 10th
Neutral: above 10th
Negative signal NOT in the past 6 months:
Negative: below 10th
Neutral: 10th to 25th
Positive: above 25th
Consumer sentiment Negative signal in the past 12 months: 12/1/1982 – 8/1/2023
Negative: below 10th
Neutral: above 10th
Negative signal NOT in the past 12 months:
Negative: below 10th
Neutral: 10th to 15th
Positive: above 15th
Jobless claims--adjusted by labor force Negative: above 75th 1/1/1978 – 7/1/2023
Neutral: 50th to 75th
Positive: less than 50th
Freight Transportation Services Index--annual growth rate Negative: below 10th 1/1/2000 – 6/1/2023
Neutral: 10th to 15th
Positive: above 15th
Building Permits (single family)--annual growth rate Negative: below 25th 1/1/1978 – 7/1/2023
Neutral: 25th to 40th
Positive: above 40th
ISM (MFG) New Orders Index Negative: below 50 1/1/1978 – 7/1/2023
Neutral: 50 to 52.9
Positive: above 52.9
National Financial Conditions Index Negative: above 65th 12/1/1982 – 8/1/2023
Neutral: 40th to 65th
Positive: less than 40th
Fed’s loan survey Recession in the past 12 months: 1996 Q1 – 2023 Q3
Negative: above 80th
Neutral: 25th to 80th
Positive: less than 25th
Recession NOT in the past 12 months:
Negative: above 50th
Neutral: 25th to 50th
Positive: less than 25th
Conventional interpretations

Although we use the traditional statistical methods, we are still aware of the widely used standards for interpreting the leading indicators.

Conventional interpretations for selected leading indicators
Leading indicators Negative signs for the economy
Term spread Inverted yield curve/term spread falls below zero.
S&P500 Correction: a 10% or greater decline from its most recent peak; Bear market: at least 20% drop from its previous high.
Initial jobless claims Initial claims standing above 350,000 for several weeks is symptomatic of an economy that’s losing steam and in danger of slipping into recession.
Building permits (single-family) Single-family building permits fall below 800,000.
ISM (MFG) New Orders Index A PMI® reading above 50% indicates that the manufacturing economy is generally expanding; below 50% indicates that it is generally declining. A PMI® above 42.9%, over a period of time, indicates that the overall economy, or GDP, is generally expanding; below 42.9%, it is generally declining. The distance from 50% or 42.9% is indicative of the extent of the expansion or decline.
Chicago Fed NFCI Index Positive values: financial conditions tighter than average; Negative values: financial conditions looser than average.
Sources: Federal Reserve, Institute for Supply Management, Bernard Baumohi: The Secrets of Economic Indicators (3rd edition).

The views expressed here are the independent opinions of S&P Global Ratings' economics group, which is separate from but provides forecasts and other input to S&P Global Ratings' analysts. S&P Global Ratings' analysts use these views in determining and assigning credit ratings in ratings committees, which exercise analytical judgment in accordance with S&P Global Ratings' publicly available methodologies.

This report does not constitute a rating action.

Chief Economist, U.S. and Canada:Satyam Panday, San Francisco + 1 (212) 438 6009;
Research Contributors:Shruti Galwankar, CRISIL Global Analytical Center, an S&P affiliate, Mumbai
Soumyadip Pal, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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