A coming recession is signaled by the forward rate report

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It is well known that an interest rate environment in which long-term debt instruments underperform short-term debt instruments of the same credit quality is considered a predictor of recessions. It is reasonable to assume that a similar pattern will prevail ahead of future contractions in the economy.

This model uses 2-year and 10-year US Treasury yields as measures of short-term and long-term rates, respectively, and calculates the forward rate ratio (FRR2-10) between the two rates.

FRR2-10 is the rate at which a loan can be locked in for the eight-year period starting in two years, divided by the ten-year rate itself. A FRR2-10 above 1.00 indicates a positively sloped yield curve (yields on ten-year notes are higher than yields on two-year notes); a FRR2-10 below 1.00 indicates an inverted yield curve (yields on two-year notes are higher than yields on ten-year notes). For the Forward Rate Ratio calculation formula, see the Appendix.

Forward rate ratio at 1.00

iMarketSignals

In Figure 1, the smoothed FRR2-10 shown is the exponential moving average of FRR2-10 (daily values) with a constant smoothing factor equal to 0.030. It can be seen that the yield curve was inverted prior to the last seven recessions (indicated by the forward rate ratio of 2- and 10-year yields below 1.00). Currently (August 5, 2022), the yield curve is inverted with FRR2-10 at 1.00 indicating that we are entering the boom phase of the business cycle and approaching the next recession, as shown in Figure 2.

Business cycle phases

iMarketSignals

The dotted vertical red lines indicate when the smoothed FRR2-10 fell below 1.00. The dates and times of subsequent recessions are shown in the table below. The minimum delay was 39 weeks before the recessions of 1973 and 1981, the average being 62 weeks or 14 months.

Recessions FFR2-10 To lead to Recession

To lead to Recession

Begin End Signal date (weeks) (years)
January-70 Nov-70 05/01/68 87 1.68
Dec-73 March-75 03/06/73 39 0.75
Feb-80 Jul-80 10/09/78 69 1.32
Aug-81 Nov-82 11/03/80 39 0.75
Aug-90 March-91 02/22/89 75 1.44
Apr-01 Nov-01 03/17/00 54 1.05
Jan-08 Jun-09 08/29/06 70 1.35
March 21st Apr-21

It is also evident that the stock market posted gains for a few months after the FRR2-10 fell below 1.00, synonymous with the boom phase of the business cycle.

Annex

Forward rate ratio

The FRR is described in an article by Howard L. Simons in Stocks, Futures and Option Magazine, March 2007 and can be calculated for any two rates on the yield curve.

FRR2-10 is the rate at which a loan can be locked in for the eight-year period starting in two years, divided by the ten-year rate itself.

The FRR2-10 calculation formula is: FRR2-10 = { [(1 + i10)10 / (1 + i2)2 ]1/8 -1} / itenOr Iten and me2 are the yields of 10-year and 2-year US Treasury bonds, respectively.

Neglect compound interest: FRR2-10 = (5 iten – I2 ) / 4 iten

Sallie R. Loera