Is the economy headed into recession? If so, could this weird chart contain the secret to finding out when a downturn might begin? New research from the Federal Reserve suggests that the answer might be yes.
A recent research piece by the Richmond Fed’s Anne Lundgaard Hansensuggests the above chart contains the best indicator of turning points in the business cycle. Her paper, “Predicting Recessions Using VIX-Yield-Curve Cycles,” is based on research into the cyclical relationship between monetary policy and market volatility that CME Group began publishing five years ago.
In order to make sense of the data, let’s break it down into bite-sized pieces. What initially looks like random noise is actually a repeating cyclical pattern that breaks down into four parts.
First, recessions happen following periods of tight monetary policy, characterized by flat yield curves and high levels of equity volatility.
Second, once a recession gets underway, the Fed eases policy, steepening the yield curve.
Third, by the middle of an expansion, equity volatility subsides, and the Fed begins to tighten policy.
Fourth, in the late stages of an expansion, a tight monetary policy has flattened the yield curve, and equity market volatility begins to rise before the economy dips into another downturn.
Over the last 31 years, the cycle has repeated three times, but recently it has taken a new twist. Fed tightening is beginning to flatten the yield curve and equity volatility is beginning to rise. So, we might be headed into the lower right-hand corner of the chart, the part typically associated with recessions. But we are not there yet.
OpenMarkets is an online magazine and blog focused on global markets and economic trends. It combines feature articles, news briefs and videos with contributions from leaders in business, finance and economics in an interactive forum designed to foster conversation around the issues and ideas shaping our industry.
All examples are hypothetical interpretations of situations and are used for explanation purposes only. The views expressed in OpenMarkets articles reflect solely those of their respective authors and not necessarily those of CME Group or its affiliated institutions. OpenMarkets and the information herein should not be considered investment advice or the results of actual market experience. Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs) within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments and, because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for either a futures or swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles and only a portion of those funds should be devoted to any one trade because traders cannot expect to profit on every trade. BrokerTec Americas LLC (“BAL”) is a registered broker-dealer with the U.S. Securities and Exchange Commission, is a member of the Financial Industry Regulatory Authority, Inc. (www.FINRA.org), and is a member of the Securities Investor Protection Corporation (www.SIPC.org). BAL does not provide services to private or retail customers.. In the United Kingdom, BrokerTec Europe Limited is authorised and regulated by the Financial Conduct Authority. CME Amsterdam B.V. is regulated in the Netherlands by the Dutch Authority for the Financial Markets (AFM) (www.AFM.nl). CME Investment Firm B.V. is also incorporated in the Netherlands and regulated by the Dutch Authority for the Financial Markets (AFM), as well as the Central Bank of the Netherlands (DNB).