This Recession Indicator Has a 100% Track Record, Heres What It Just Did | Jeff Snider (YouTube link)
In the above video, the discussion between the host and Jeff Snyder focuses on the bond market, particularly the "perfect predictor" indicator, which historically signaled a recession within 12 months when triggered. This indicator, based on forward spreads derived from term spreads, was activated in August 2023 but failed to predict a recession by August 2024, challenging its reliability. They explore reasons for this failure, questioning whether the indicator itself is flawed or if the National Bureau of Economic Research (NBER) recession definition is outdated.
Key points include:
- Perfect Predictor Indicator: Developed using 654 million data points, it relies on longer-dated forward spreads (e.g., Eurodollar or SOFR futures) that signal recessions when they invert and persist. Historically, it had no false positives or negatives since 1960, but its recent failure prompts scrutiny.
- Potential Distortions: The host suggests that Federal Reserve actions, like quantitative easing (QE), might distort term spreads by affecting collateral availability, potentially skewing forward spreads. However, Snyder argues that QE doesn’t significantly lower long-term rates, as seen in higher 10-year Treasury yields after QE rounds.
- Economic Context: Snyder posits that the economy may still be in a prolonged recession from the 2020 pandemic, with weak labor market recovery (e.g., 5.5 million jobs short of pre-pandemic levels) and other recession-like signals (e.g., real income excluding transfers). This suggests the indicator may not be wrong but reflects ongoing economic weakness not captured by NBER’s traditional metrics.
- NBER’s Recession Definition: The NBER’s reliance on metrics like non-farm payrolls and GDP may miss broader economic weakness, as recessions today differ from post-World War II patterns. Snyder argues that market signals, like forward spreads, reflect real economic conditions better than NBER declarations.
- Supply and Demand in Bond Markets: The host and Snyder debunk the idea that Treasury supply or Fed buying drives interest rates. Instead, banks and financial institutions act as an equilibrating force, buying or selling based on growth and inflation expectations, not just supply. For example, banks arbitrage spreads (e.g., 2% funding cost vs. 4% Treasury yield) regardless of inflation, prioritizing risk-adjusted returns.
- Global vs. U.S. Signals: The host suggests the indicator might reflect global economic weakness rather than U.S.-specific conditions, as Treasury markets serve the global economy. Snyder agrees, noting persistent global and U.S. economic issues.
- Market Implications: Despite the indicator’s signals, market participants may focus on NBER recession declarations for trading decisions, creating a disconnect between market signals and economic reality.
In summary, the failure of the "perfect predictor" may stem from an outdated recession definition or unique economic conditions in the 2020s, not a flaw in the indicator itself. The discussion emphasizes the importance of understanding financial institutions’ actions and the limitations of traditional economic metrics.
Perfect Predictor Indicator
Core Component
The core component of the Perfect Predictor Indicator is forward spreads, which are derived from term spreads in bond markets. Here’s a breakdown of these concepts:
- Term Spreads: These represent the difference in yields between bonds of different maturities, such as the 10-year Treasury note minus the 2-year Treasury note. A widely watched term spread is the 10-year/2-year Treasury yield spread, which often inverts (turns negative) before recessions, signaling that investors expect lower yields (and weaker economic conditions) in the future.
- Forward Spreads: These are a more complex derivative of term spreads, calculated from forward rates, which represent the expected future interest rates implied by current bond yields. Forward spreads measure the difference between forward rates for different time horizons. For example, a forward spread might compare the implied 3-month interest rate starting 5 years from now to the 3-month rate starting 6 years from now.
- Eurodollar and SOFR Futures: The indicator specifically uses forward spreads derived from Eurodollar futures (contracts based on short-term U.S. dollar interest rates in the offshore market) or SOFR futures (based on the Secured Overnight Financing Rate, a benchmark for U.S. dollar borrowing costs). These futures contracts reflect market expectations of future interest rates and are traded in large volumes, making them a reliable gauge of investor sentiment. The indicator focuses on longer-dated contracts (e.g., those maturing 4+ years out), as these are less influenced by short-term Federal Reserve policies and more reflective of independent market expectations about economic growth and inflation.
Recession Signals
The Perfect Predictor Indicator signals a recession when specific longer-dated forward spreads invert and persist in that inverted state:
- Inversion: A forward spread inverts when the yield on a longer-dated future contract (e.g., a 5-year forward rate) falls below that of a shorter-dated one (e.g., a 4-year forward rate). This inversion suggests that markets anticipate weaker economic conditions or lower interest rates in the future, often associated with a recession. For example, an inverted yield curve (a related concept) occurs when short-term yields exceed long-term yields, signaling investor pessimism about near-term growth.
- Persistence: The indicator doesn’t trigger on fleeting inversions. Instead, it requires the inversion to "stick" for a sustained period, typically measured using a moving average to smooth out short-term volatility. This persistence ensures that the signal is robust and not triggered by temporary market noise.
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