The chances of a recession within the next 12 months continues to rise as the yield curve flattens.

Mark Fleming, First American Finance Corp. chief economist, explained the Fed’s quantitative easing program, its plan for what to do with the $1.75 trillion in mortgage backed securities it began buying in 2009, is important for several reasons.

“The yield curve, which indicates how much the government has to pay to borrow money for different lengths of time is a great indicator of the expectations for the economy in the future,” Fleming said. “In fact, the yield curve is a leading indicator of recession.”

“As the yield curve flattens, differences between short-term and long-term rates become small, or even inverts, long-term rates less than short-term rates, the likelihood of a recession increases,” he said. “Quantitative uneasing helps to increase long-term rates and prevent the flattening of the yield curve.”

This chart shows the probability of a recession as predicted by the Treasury spread:

Click to Enlarge


(Source: New York Fed, First American)

“Based on an analysis of the yield curve from the New York Fed, the yield curve is flattening and the risk of a recession is rising,” Fleming said. “Currently, the estimated probability of a recession in the next four quarters is just over 5%.”

“That may seem low, but if you look at the chart below one can see that anything significantly above zero and more importantly, rising, can be a strong indicator of future recession risk,” he said. “I think the probability that the FOMC knows this is much higher than 5%.”

However other economists put a much higher chance of recession. Mike Fratantoni, Mortgage Bankers Association chief economist, predicted a 15% to 20% chance of a recession over the next 12 months, while Fannie Mae Chief Economist Doug Duncan pushed it to a 30% chance.

At the MBA National Secondary Conference and Expo in New York City, Freddie Mac Chief Economist Sean Becketti emphasized that while the chance of a recession increased, it would need to be driven by a specific event.

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