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Update: Fed Model

By beled | October 1, 2018

Extract from the June 2018 quarterly report:

As stated in our previous report, we believe that Trump is using tariffs as a negotiating tactic to level an undoubtedly tilted playing field and that contrary to popular perception average global tariffs ultimately may end up lower. Support for this view is the world’s largest free trade agreement recently concluded between the EU and Japan which, although the US was not a party to it, is a step in the right direction.

Rising short term interest rates in the US are of greater concern if the US Federal Reserve (Fed) is too “hawkish” and raises interest rates too much. In the past this has led to yield curve inversion (short rates higher than long rates) followed by economic recession and equity bear markets. This is encapsulated in a model developed by Arturo Estrella and Frederic S. Mishkin of the New York Fed who developed a robust recession-prediction model based on yield curve inversion (“The Yield Curve as a Predictor of U.S. Recessions” 1996). In this paper they claim that the yield curve—specifically, the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill—is a valuable forecasting tool. It is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead. Although no model is perfect, it is comforting that this model is still showing a low probability of recession (chart 1):


Chart 1: New York Fed model and probability of recession in next 12 months


We conclude that while there may be volatility due to both the above-mentioned factors, on balance neither yet indicate a negative outlook for both the world economy and equity investments.

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