Category Archives: European Banks International Monetary Fund

The Next Border Fence

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Apparently, they do work and have some significant value, in Europe that is. With the constant flow of migrants, several major problems have literally cracked the security of countries.  Further, there are no signs that migrants flowing into Europe will wane or stop at all, so the true costs in 2016 or beyond. The immigration flood in Europe is a clarion call to the United States as the issues are virtually the same. Not only is the United States taking in Middle Eastern refugees, but we have been taking in Cubans, Mexicans, as well as Central and South Americans. For America is goes much further that a trifecta and costs and security.

Anti-migrant force builds in Europe, hurting Merkel’s quest

WARSAW, Poland (AP) — So where should the next impenetrable razor-wire border fence in Europe be built?

Hungary’s right-wing Prime Minister Viktor Orban thinks he knows the best place – on Macedonia’s and Bulgaria’s borders with Greece – smack along the main immigration route from the Middle East to Western Europe. He says it’s necessary because “Greece can’t defend Europe from the south” against the large numbers of Muslim refugees pouring in, mainly from Syria and Iraq.

The plan is especially controversial because it effectively means eliminating Greece from the Schengen zone, Europe’s 26-nation passport-free travel region that is considered one of the European Union’s most cherished achievements.

Orban’s plan will feature prominently Monday at a meeting in Prague of leaders from four nations in an informal gathering known as the Visegrad group: Hungary, Poland, the Czech Republic and Slovakia. The Visegrad group, formed 25 years ago to further the nations’ European integration, is marking that anniversary Monday. Still, it has only recently found a common purpose in its unified opposition to accepting any significant number of migrants.

This determination has emboldened the group, one of the new mini-blocs emerging lately in Europe due to the continent’s chaotic, inadequate response to its largest migration crisis since World War II. The Visegrad group is also becoming a force that threatens the plans of German Chancellor Angela Merkel, who wants to resettle newcomers across the continent while also slowing down the influx.

“The plan to build a new “European defense line” along the border of Bulgaria and Macedonia with Greece is a major foreign policy initiative for the Visegrad Four and an attempt to re-establish itself as a notable political force within the EU,” said Vit Dostal, an analyst with the Association for International Affairs, a Prague based think tank.

At Monday’s meeting, leaders from the four nations will be joined by Macedonian President Gjorge Ivanov and Bulgarian Prime Minister Boiko Borisov so they can push for the reinforcements along Greece’s northern border. Macedonia began putting up a first fence in November, and is now constructing a second, parallel, fence.

“If it were up only to us Central Europeans, that region would have been closed off long ago,” Orban said at a press conference recently with Poland’s prime minister. “Not for the first time in history we see that Europe is defenseless from the south … that is where we must ensure the safety of the continent.”

Poland has indicated a willingness to send dozens of police to Macedonia to secure the border, something to be decided at Monday’s meeting.

“If the EU is not active, the Visegrad Four have to be,” Slovak Prime Minister Robert Fico said recently. “We have to find effective ways of protecting the border.”

The leaders will try to hash out a unified position ahead of an important EU meeting Thursday and Friday in Brussels that will take up both migration and Britain’s efforts to renegotiate a looser union with the EU. The Visegrad countries have also recently united against British attempts to limit the welfare rights of European workers, something that would affect the hundreds of thousands of their citizens who now live and work in Britain.

The anti-migrant message resonates with the ex-communist EU member states, countries that have benefited greatly from EU subsidies and freedom of movement for their own citizens but which now balk at requests to accept even small numbers of refugees. The Visegrad nations maintain it is impossible to integrate Muslims into their societies, often describing them as security threats. So far the Poles, Czechs and Slovaks have only accepted small numbers, primarily Christians from Syria.

Many officials in the West are frustrated with what they see as xenophobia and hypocrisy, given that huge numbers of Poles, Hungarians and other Eastern Europeans have received refuge and economic opportunity in the West for decades.

Indeed there are plenty of signs that the countries are squandering a lot of the good will that they once enjoyed in the West for their sacrifices in throwing off communism and establishing democracies.

Orban’s ambitions for Europe got a big boost with the rise to power last year in Poland of the right-wing Law and Justice party, which is deeply anti-migrant and sees greater regional cooperation as one of its foreign policy priorities. Polish Prime Minister Beata Szydlo’s government says it wants to do more to help Syrian refugees at camps in Turkey and elsewhere while blocking their entry into Europe.

Although Orban is alienating Greek authorities, who are staggering under the sheer numbers of asylum-seekers crossing the sea from Turkey in smugglers’ boars, he insists he must act as a counterweight to Western leaders, whom he accuses of creating the crisis with their welcoming attitude to refugees.

“The very serious phenomenon endangering the security of everyday life which we call migration did not break into Western Europe violently,” he said. “The doors were opened. And what is more, in certain periods, they deliberately invited and even transported these people into Western Europe without control, filtering or security screening.”

Dariusz Kalan, an analyst at the Polish Institute of International Affairs, said he doesn’t believe that the Visegrad group on its own can destroy European unity but says Orban’s vision is winning adherents across the continent in far-right movements and even among mainstream political parties.

“It’s hard to ignore Orban,” Kalan said. “People in Western Europe are starting to adopt the language of Orban. None are equally tough and yet the language is still quite similar.”

China banks may lose 5 times US banks’ subprime losses

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Yellin’s testimony includes China as the big worry.   

China is big concern

Yellen didn’t mince words about China: its economy is slowing down and uncertainty is rising about how much China will devalue its currency, the yuan.

A weak yuan has major implications for global trade. Yellen firmly blames the uncertainty of China’s currency for the rise in global growth fears.

“This uncertainty led to increased volatility in global financial markets and, against the background of persistent weakness abroad, exacerbated concerns about the outlook for global growth,” Yellen said.

Add in spooky dude, George Soros:

Bass: China banks may lose 5 times US banks’ subprime losses in credit crisis

CNBC: A Chinese credit crisis would see the country’s banks rack up losses 400 percent larger than the hit U.S. banks took during the subprime mortgage crisis, storied hedge fund manager Kyle Bass has warned in a letter to investors.

“Similar to the U.S. banking system in its approach to the Global Financial Crisis (GFC), China’s banking system has increasingly pursued excessive leverage, regulatory arbitrage, and irresponsible risk taking,” Bass, the founder of Dallas-based Hayman Capital, wrote in the letter dated Wednesday.

“Banking system losses – which could exceed 400 percent of the U.S. banking losses incurred during the subprime crisis – are starting to accelerate.”

China’s banking system has grown to $34.5 trillion in assets over the past 10 years, from a base of $3 trillion, wrote Bass, who is famed as one of the few major investors to correctly call the U.S. subprime housing collapse that kicked off the 2008 global financial crisis. That prescience earned him a mention in Michael Lewis’ book “Boomerang,” which was about the European credit crisis.

This expansion in the banking system’s asset base was fueled largely by rapid credit expansion, Bass wrote, that helped fund the huge, and often inefficient, infrastructure spending program that has propped up China’s growth.

“China’s [banking] system is even more precarious when we realize that, even at the biggest banks, loans are not made to borrowers based on their ability to repay,” he wrote. “Instead, load decisions are political decisions made by the state.”

Add to this the danger posed by China’s shadow banking system – made up of instruments Bass claimed the country’s banks used to subvert restrictions on lending – and the upshot was there were “ticking time bombs” in China’s banking system, the hedge fund manager explained.

“Chinese banks will lose approximately $3.5 trillion of equity if China’s banking system loses 10 percent of assets,” Bass wrote. “Historically, China has lost far in excess of 10 percent of assets during a non-performing loan cycle.”

He noted that U.S. banks lost about $650 billion of their equity throughout the global financial crisis.

The letter said that the Bank for International Settlements (BIS) estimated that Chinese banking system losses from the 1998-2001 non-performing loan cycle exceeded 30 percent of gross domestic product (GDP).

“We expect losses in this cycle to exceed prior cycles. Remember, 30 percent of Chinese GDP approaches $3.6 trillion today,” he warned.

Bass wrote that he expected the massive losses to force Beijing to recapitalize Chinese banks and sharply devalue the yuan.

“China will likely have to print in excess of $10 trillion worth of yuan to recapitalize its banking system,” he said. “By the time the loss cycle has peaked, we believe the renminbi will have depreciated in excess of 30 percent versus the U.S. dollar.”

The hedge fund manager didn’t return an email sent outside office hours requesting comment on the investor letter, which the Wall Street Journal reported was the first he had sent in two years.

Bass’ sentiments on the yuan aren’t new, with the Wall Street Journal reporting earlier this month that he was among the money managers making bearish bets on the currency.

The dollar has already fallen about 5.9 percent against the yuan since August, when a sharp devaluation by the People’s Bank of China (PBOC) roiled markets; the greenback was fetching around 6.5710 yuan on February 5, the last day of trade before China’s markets closed for a week-long Lunar New Year holiday.

The PBOC has introduced a slew of measures to arrest, or at least slow, declines in the currency in the hope of achieving an orderly depreciation.

The central bank has asked banks making yuan loans abroad to set aside more in reserves and has also hoovered up yuan in Hong Kong, a key market where the bearish bets have been made, effectively making it more expensive for traders to borrow the yuan to make these trades.

China’s state-owned publications have also chipped in with stinging editorials admonishing greedy speculators for betting against the currency. Prominent investor George Soros was recently likened to a “crocodile” that had declared “war” on China for suggesting while at the World Economic Forum in Davos, Switzerland, that China’s economy was headed for a hard landing.

In his letter, Bass casts the attacks on Soros as confirmation of his views.

“China’s public reaction in its state media to George Soros’ comments in Davos was in character for a country that is on the precipice of a large devaluation,” Bass said.

While many have pointed to China’s large – albeit shrinking – pile of $3.23 trillion in foreign-exchange reserves as a defensive wall against a crisis, Bass says that’s simply not enough.

He estimates China really only has around $2.1-2.2 trillion in reserves after adjusting for several factors including about $700 billion that could be tied up in China’s sovereign wealth fund CIC. That’s below his estimate of the $2.7 trillion minimum China would need to effect a banking sector bailout.

“China’s liquid reserve position is already below a critical level of minimum reserve adequacy,” he said.

Predictions of a Chinese economic disaster have been circulating for a long time; Gordon Chang’s book “The Coming Collapse of China” was published in 2001.

However, the mainland saw economic growth slow to a 25-year low of 6.9 percent in 2015 amid its transition toward a consumption-driven economy and away from its manufacturing roots.

When it comes to positioning for his expectations of a Chinese bank implosion, Bass wrote that he was thinking broad.

“What happens in China will not stay in China,” he said. “We decided to liquidate the majority of our risk assets.”

He did not appear likely to buy back in to the market any time soon.

“The next 18 months will be fraught with false-starts, risk rallies, and second-guessing,” he wrote.

To be sure, some of Bass’ other doomsday bets haven’t yet come to fruition.

For more than five years, he has called for a collapse in Japan government bonds (JGB) as part of a yet-to-materialize full-blown financial crisis there. That trade, dubbed a widow-maker, has so far backfired spectacularly.

Instead of a collapse in JGB prices, they’ve surged, with the benchmark 10-year seeing negative yields for the first time this week. Bond yields move inversely to prices.

Hayman Capital had returns of about 1.7 percent last year, according to a Bloomberg report.

***

TOKYO (AP) — Japan’s main stock index dived Friday, leading other Asian markets lower, after a sell-off in banking shares roiled investors in the U.S. and Europe.

Tokyo’s Nikkei 225 was down 4.8 percent to 14,952.61 after earlier sinking as much as 5.3 percent. Hong Kong’s Hang Seng fell 1.0 percent to 18,364.14. South Korea’s Kospi gave up 1.4 percent to 1,835.01 and Australia’s S&P/ASX 200 fell 1.2 percent to 4,765.30. Shares in New Zealand and Southeast Asia also fell. Markets in China and Taiwan are closed until Monday for Lunar New Year holidays.

Global stocks have been in a slump since the beginning of the year when China’s market, which had been propped up by government buying, plunged dramatically. Concerns about China, however, are now just one of several factors behind the bloodletting.

Keeping Islamic State from Money Exchanges

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Denying The Islamic State Access To Money-Exchange Houses

Energy: Regional regulators must take steps, as the Iraqi Central Bank has done, to wall off their financial systems from unlicensed or loosely regulated money remitters vulnerable to exploitation by the Islamic State.

This week, the entity known as the Foreign Ministers of the Small Group of the Global Coalition to Counter ISIL/Da’esh met in Rome to assess the coalition’s work and accelerate its efforts to degrade and ultimately defeat the Islamic State. In a statement, the ministers stressed that they “are determined to keep ISIL/Da’esh cut off from the international financial system [and] to disrupt its economic and financial infrastructure.” Making good on this pledge requires tackling the group’s access not only to banks but also to remittance providers such as exchange houses, which play an important role in the local economies and are more difficult to regulate. In December, the Central Bank of Iraq took action against nearly 150 Iraqi money-exchange companies — most, but not all, in Islamic State-controlled areas — showing how U.S. and regional regulators, along with other coalition partners, can join forces to isolate the group from the international financial system.

BACKGROUND

Given the Islamic State’s 2014 budget of roughly $2 billion, U.S. Department of Treasury officials have called the group’s ability to draw revenues from its own territory “unprecedented.” The sources of funds include between $500 million and $1 billion seized from bank vaults as the Islamic State gained territory (a onetime take), hundreds of millions a year from taxation and extortion, and tens of millions a month from oil sales, among other sources. While the Islamic State derives most of its income from the territory it controls, denying the Islamic State the ability to use bank branches and exchange houses in its territory to make and receive international transfers — to access foreign currency, procure goods, and finance foreign fighters and potentially foreign affiliates — is a critical part of isolating the group.

Military strikes have played an increasingly important role in degrading the Islamic State’s ability to derive income from resources in the territory it controls. Furthermore, given that the Islamic State derives most of its income from natural resource extraction and extortion directed at commercial activity, territorial losses will have a direct impact on the organization’s bottom line. Recently, airstrikes have also targeted Islamic State cash collection and distribution points, depriving the group of millions of dollars stored at these “cash depots,” according to military estimates.

Previously, the Iraqi government and other regional regulators have taken steps to cut off bank branches in Islamic State territory from participating in the broader financial system. The United States and other countries, together with Iraqi authorities, headquarters of international banks, and others within the international financial community, have partnered to counter the Islamic State’s backdoor banking through these bank branches, as well as those in Syria. International banks now look closely for indications of Islamic State financing and file suspicious activity reports that, U.S. authorities say, have provided “valuable insight into financial activity in areas where ISIL operates.” The Central Bank of Iraq instructed financial institutions incorporated in Iraq to prevent wire transfers to and from banks located in areas under Islamic State control, and international banks with regional branches in Islamic State-controlled territories have relocated staff away from areas around the group’s territories.

Another area of effort is limiting new funds entering Islamic State territory through countersmuggling initiatives and by ceasing to pay Iraqi government salaries, which had been taxed directly and indirectly by the Islamic State, in areas under the group’s control. As pressure mounts on the Islamic State’s backdoor banking, the group has become more reliant on money-exchange houses to send and receive funds. More explanation and details here.

Meanwhile, there is finally those who are declaring Russia is aiding Islamic State:

US says Russian campaign in Syria helping the Islamic State

WASHINGTON (AP) — The U.S. says Russia’s counterterrorism campaign in Syria is actually helping the Islamic State.

Brett McGurk, the Obama administration’s point-man for defeating the group, says a Russian-backed offensive in northern Syria is targeting rebel fighters who were battling the Islamic State and who now have to face the Syrian military.

McGurk tells the House Foreign Affairs Committee, “What Russia’s doing is directly enabling ISIL.”

He says Russia is strengthening the Syria’s government, worsening a humanitarian crisis and fueling extremism. McGurk, who will meet Russian and other diplomats at a conference on Syria later this week, called the developments “totally unacceptable.”

Clapper Breaks with Obama’s Threat Crisis Plank

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North Korea has restarted plutonium reactor: US

North Korea has restarted a plutonium reactor that could fuel a nuclear bomb and is seeking missile technology that could threaten the United States, Washington’s top spy said on Tuesday.

Intel Chief Breaks From Obama Narrative On Iran Deal

DailyCaller: The head of U.S. intelligence believes that Iran’s recent actions speak loudly to its intentions, particularly given the country’s recent provocations since the Iran nuclear deal came into effect.

Testifying to the Senate Committee on Armed Services Tuesday, director of national intelligence James Clapper gave a very somber description of what he sees as Iran’s intentions toward the U.S. now that last summer’s nuclear deal has commenced. In particular, his statements offered little assurance that Iran is acting as an honest actor with the U.S. and the other states involved in last year’s negotiations, or that the nuclear deal will stop Iran from obtaining a nuclear weapon.

“Iran probably views JCPOA [Iran deal] as a means to remove sanctions while preserving nuclear capabilities, as well as the option to eventually expand its nuclear infrastructure,” said Clapper, who also noted that, so far, he sees no evidence that Iran is violating the nuclear deal.

Clapper’s statements stand in stark contrast with those made by President Barack Obama, who lauded the nuclear accord last summer, claiming it would not only stop all of Iran’s possible pathways to a nuclear weapon, but that “under its terms, Iran is never allowed to build a nuclear weapon.” More here.

***

Clapper went into all specifics on the threat matrix both at home and globally. He did not leave anything behind, from cyber wars, space wars, weapons systems, human trafficking, terror organizations, economic instability, migrants, disinformation and drug cartels.

 STATEMENT FOR THE RECORD WORLDWIDE THREAT ASSESSMENT of the US INTELLIGENCE COMMUNITY
February 9, 2016
INTRODUCTION
Chairman McCain, Vice Chairman Reed, Members of the Committee, thank you for the invitation to offer
the United States Intelligence Community’s 2016 assessment of threats to US national security. My statement reflects the collective insights of the Intelligence Community’s extraordinary men and women, whom I am privileged and honored to lead. We in the Intelligence Community are committed every day to provide the nuanced, multidisciplinary intelligence that policymakers, warfighters, and domestic law enforcement personnel need to protect American lives and America’s interests anywhere in the world.
 The order of the topics presented in this statement does not necessarily indicate the relative importance or magnitude of the threat in the view of the Intelligence Community. Information available as of February 3, 2016 was used in the preparation of this assessment.
 
TABLE OF CONTENTS
 
GLOBAL THREATS Cyber and Technology Terrorism Weapons of Mass Destruction and Proliferation Space and Counterspace
 
Counterintelligence Transnational Organized Crime
 
Economics and Natural Resources Human Security
 
REGIONAL THREATS East Asia
China Southeast Asia North Korea
Russia and Eurasia
Russia Ukraine, Belarus, and Moldova The Caucasus and Central Asia
Europe
 
Key Partners The Balkans Turkey Middle East and North Africa 
Iraq Syria Libya  Yemen Iran  Lebanon Egypt Tunisia
 
South Asia
Afghanistan Bangladesh Pakistan and India
Sub-Saharan Africa  Central Africa Somalia South Sudan Sudan Nigeria
 
Latin America and Caribbean
 
Central America Cuba Venezuela Brazil
 

 

 

 

 

What do Banks Say About the Recession?

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What do economists have in their forecasts?

It is important to watch other countries performance like China, Greece and Brazil:

Bank Of America Admits The U.S. May Already Be In A Recession

Zerohedge: Almost one year ago, in March 2015, we explained how “The Fed’s Artificial Steepening Of The Yield Curve” has resulted in many unexpected consequences, the most important of which has been the erroneous interpretation of the yield curve as a leading recessionary signal. As said back then, “the artificially steep yield curve is a reflection of policy intent not economic reality…. Where the yield curve in the all-important belly of the 5s10s might have deeply inverted in the past just prior to recession, there is no justification to expect the same attainment of absolute levels where artificial monetary intrusion has pushed the curve much, much steeper.”

One week ago, it was as if a light bulb went off over Wall Street’s head, when first Deutsche Bank’s Dominic Konstam realized the significance of the above excerpt, and admitted that far from the 4% recession odds that the Fed’s hopeless FRB/US DSGE computer model spews out when looking at the “normal” yield curve, when normalizing for the Fed’s intervention odds of a recession in the next 12 months soar to 50%!

In a special report published earlier this week, we noted that today’s near-zero interest rate regime does not allow the yield curve to freely invert or even flatten too much because of certain structural limits. For example, liabilities-driven investors who in the past could receive long rates below the fed funds rate can no longer do so once rates are floored at zero. Investment fund managers are also restricted by mandates from buying negative yielding assets that lead to mark-to-market losses on their portfolios. Pension investors, who must target returns based on liability assumptions, have been driven into high yielding non-core rate assets as their discount rates are stubbornly and unrealistically high compared to Treasury yields. These factors keep the curve artificially steep even though both short and long rates have been clearly trending downward over the years.

An “artificially steep yield curve” – almost as if that’s exactly the phrase we used before. What DB did then is the logical next step: to adjust the artificial yield curve and exclude the Fed’s intervention. 

To address the artificial steepness of the curve we corrected the 3m10y spread for the level of the rates. Specifically we regressed the spread against the short rate, leaving the residual which by definition removes for the bias of the rate level and is centered at zero. Using this new curve as model input, we found the probability of a recession in the next 12 months is 46 percent, considerably higher than the original Fed model has predicted.

But wait, there’s more, because while the short-end remains anchored, with every 25 bps tightening in the 10Y yield, recession odds rise by another 6%.

As it may be useful for investors, we attempt to handicap the relationship between the yield curve and future recessions captured in our model. Holding the 3m rate constant, every 25 bps rally in 10s (implying an equal flattening in 3m10y) raises the recession probability by 6 percent. If 10yr yields rally to 1.50%, our model predicts a 59 percent chance of recession in the next 12 months; at 1.00% 10s, the probability is 71 percent.

 

At Friday’s close, recession odds are well over 50% according to DB’s model.

Or perhaps far higher, because shortly after DB admitted what we said in early 2015, namely that everyone who was looking at the yield curve as is was wrong, Bank of America’s Ruslan Bikbov did the exact same analysis and ended up with a far more disturbing conclusion:

The US Treasury curve is still steep by historical standards. Taken at face value, this may suggest recession odds are small. However, we argue this logic is flawed because the curve is structurally steep when the Fed Funds rate is close to zero. When adjusted for the proximity of rates to zero, the curve may already be inverted and therefore may already be priced for a recession.

And numerically: “Implied recession odds are as high as 64% if the adjusted OIS curve is used”

Laughably, this comes from the same bank whose chief economist Ethan Harris recently “predicted” US GDP for the next decade and forecast there will be no recession until 2027… the same Ethan Harris as profiled in “Perma-bears” 1 – BofA Economist 0.”

* * *

Below are the full wonkish details from BofA for all those Wall Street strategists who still hold on to the erroneous creed that recession odds are non-existent if simply looking at the unadjusted yield curve.

A leading recession indicator

We received numerous questions on the shape of the US yield curve and its relationship to recession odds. With the sharp weakening of US manufacturing data in recent months, recession risks are on everybody’s mind, while the curve has the reputation of one of the most powerful leading recession indicators. The basic fact is likely well known to our clients: each US recession since the mid 1950s (when Treasury bond data become available) was preceded by an inverted or extremely flat curve within one year before a recession start (Chart 8). This is, of course, intuitive because a flat curve reflects lower growth and/or inflation expectations. Some of our clients and market commentators pointed to this fact and the relative steepness of the curve to argue that current recession risks are rather low. Indeed, the 3m10s curve at 155bp is still far from being flat (Chart 8).

Mind the zero bound

However, we believe that a simple mechanical extrapolation of the past link between the curve and recession odds is flawed. In particular, curve-based models calibrated to pre-2009 data are likely to underestimate recession odds today. This is because with the Fed Funds at only 38bp risks for plausible Fed Funds paths are asymmetric. Although tighter policy paths are unconstrained, the room for further cuts is likely limited resulting in a steepening bias for the curve. To see this, imagine an extreme situation where the policy rate is at zero and negative rates are not feasible. In such a scenario the curve simply cannot invert, and must be necessarily biased steeper relative to its historical distribution.

Granted, we cannot rule out the possibility of negative rates in the US, but it is safe to say the Fed’s reaction function must be highly asymmetric around zero. Because negative rates entail significant risks for the financial stability of money market funds and the banking sector, the negative growth/inflation shock required for a cut below zero should be larger than positive shocks required for a hike of a comparable size. In addition, negative rates should be floored by the storage cost of currency, another reason for asymmetric risks around zero. In any case, the market currently sees only a small chance of negative rates in the US (Chart 9). The end result is structural steepness of the curve at near-zero Fed Funds levels.

Don’t wait for the curve to invert

Even a casual look at other countries with near-zero policy rates confirms that the curve does not need to flatten significantly for a recession to occur. Consider Japan, a country with the longest zero-rate history. Japan had a recession in 1991-1993, which was preceded by an inverted curve, consistent with past US experience (Chart 10). But note the call rate was at 8% when the curve inverted. Since 1995, the call rate has not exceeded 50bp. Over that period, Japan had four official (announced by the Committee for Business Cycle Indicators) recessions, none of which was preceded by an inverted curve (Chart 10).

A number of other G10 countries adopted near-zero rate policy regimes since 2008 and experienced recessions since then. Some of these recession episodes are analyzed in Table 3. We use two methods to identify recessions: technical definition (at least two consecutive quarters of negative growth) and recession dates reported by Economic Cycle Research Institute (ECRI), which employs methodology similar to that of the NBER in the US. For each recession episode, we report the range of the 3m10s government curve and the policy rate observed for a year immediately before the beginning of a recession.

Again, an inverted curve did not emerge to signal an imminent recession. In fact, in some cases the curve ahead of recessions was steeper than in the US today. As an illustration, Chart 11 shows the historical German curve. Consistent with typical US experience, the curve flattened to extreme levels ahead of each of the pre-2009 recessions. However, Germany also had a technical recession in Q4 2012-Q1 2013 when the ECB rate depo rate was at zero. Not surprisingly, the curve remained steep before that recession. In fact, the curve did not flatten below 120bp in the one-year period ahead of the recession.

Adjusting the curve for zero-rate effects

Although the curve cannot be taken at face value in a near-zero rate regime, we believe it may still provide useful information about recession odds if adjusted for the zero bound effect. The idea is to estimate a model-implied curve that could be prevalent today if negative rates were just as feasible as positive. The curve adjusted in such a way may be directly compared to its historical distribution. As a result, it may be a better recession signal than the observed curve.

Turning to technical details, we model forward rates with a truncated (at zero) normal distribution, calibrated by matching its mean and standard deviation to forward rates and at-the-money option prices. We then compute adjusted forwards as the mean of the corresponding distribution without truncation (hence, using a symmetric distribution around the mean and allowing for negative rates). Although the choice of the truncated normal distribution is somewhat arbitrary, it provides a simple tool to model the core of our argument. Because very long-dated options are not liquid, we analyze 3m5s rather than 3m10s (normally used in academic literature) Treasury curve for this analysis. We found only a small deterioration in R2 statistics for recession forecasting probit models when the 3m5s curve is used instead of 3m10s. Consistent with intuition, the 3m5s curve adjusted in such a way has been significantly flatter than actually observed curve (Chart 12).

Technical factors contributed to Treasury curve steepness

Further, the Treasury curve may be currently skewed steeper by technical factors. Treasury bonds in the belly of the curve dramatically cheapened in the past few months, which is evident from extremely tight levels of swap and OIS/Treasury spreads. As a result, the Treasury curve now looks very steep to OIS. While the 3m5s Treasury curve is at 92bp, the corresponding OIS curve is only at 56bp (Chart 13). The likely reason for this is reserve selling of foreign central banks who need to support national currencies against the recent USD appreciation. International reserves of world central banks declined by about $1tn since September 2015. At the same time, the ability of dealers to absorb the supply has declined in recent years due to regulatory pressures on balance sheets.

Conventionally, academic literature on recession forecasting uses Treasury curve data. But the Treasury curve may not be the best measure of market expectations, presumably the key component of the curve predictive power. Because of the technical nature of the recent Treasury cheapening, the OIS curve should be a better measure of market expectations, and therefore may be more relevant for  assessing recession risks.

 

The curve may be priced for a recession

Applying our methodology to the OIS curve, we found that the adjusted 3m5s OIS curve at -30bp is already inverted. This suggests that the curve already could be priced for a recession (Chart 12). Granted, our methodology signaled a false alarm in 2012 when the curve was also inverted but a recession did not follow (Chart 12). However, at that time the curve flattened to extreme levels because of the forward guidance, an unprecedented event in the history of US monetary policy. In contrast, this time the curve flattened following the Fed hike, which looks more like a typical curve inversion episode. In fact, the Fed was hiking in all previous historical episodes where the curve inverted ahead of US recessions (Chart 8). From this point of view, the current curve flattening may be more worrisome.

Implied recession odds

Our economics team sees only about a 20% probability of a recession in the next year. They argue that the two most important causal factors in recession–aggressive Fed tightening in a battle against above-target inflation and very high oil prices–are not evident today. They also argue that both “real” and financial bubbles are small. The only sector that overexpanded in the recovery is the tiny oil and gas sector (about 2% of the economy at the peak) and the high yield sector overshot fundamentals, but it is much less important than the housing and equity market bubbles of the last two cycles.

Nonetheless, clearly markets are worried and an indicator we have developed confirms their concerns. To quantify implications from the inversion of the adjusted curve, we follow academic literature to compute model-implied recession probabilities from a standard probit regression based on the curve. We acknowledge this type of a model is highly simplistic and does not take into account all the complexities of today economic environment. Still, model probabilities may be interesting to know given the curve’s track record.

We estimated a standard probit model to pre-2009 sample when zero rates were not an issue. We then computed implied probability of a recession within next 12 months with different assumptions about the proper curve to be used in the current regime (Table 4). The model implies about 32% recession odds if the Treasury curve is taken at face value. Just using OIS instead of Treasury rates brings this probability to about 42%. Implied recession odds are as high as 64% if the adjusted OIS curve is used (Table 4).