The Course of History Just Changed…

Key Concepts

• Federal Reserve Recession Model: A model developed by the US Federal Reserve to estimate the probability of a recession within the next 12 months.
• Yield Curve: A graphical representation of the yields of bonds with different maturities. Inverted yield curves (where short-term yields are higher than long-term yields) are often seen as a recessionary signal.
• Liquidity: The ease with which an asset can be converted into cash. Tight liquidity suggests less money available in the financial system, potentially leading to an economic slowdown. Loose liquidity indicates more money available.
• Unemployment Rate: The percentage of the labor force that is jobless and actively seeking employment.
• Lending Standards: The criteria that banks use to decide whether to lend money to borrowers. Tightening lending standards means banks are becoming more restrictive in their lending.
• ADP Job Report & Non-Farm Payroll Report: Key US government reports that track job creation in the economy.
• Great Financial Crisis (2008): A severe worldwide economic crisis that began in 2008.
• 2001 Recession: A recession in the US economy that occurred in 2001.
• S&P 500: A stock market index that represents 500 of the largest publicly traded companies in the United States.

Federal Reserve Recession Model and Yield Curve Dynamics

The video discusses the US Federal Reserve's own recession model, which aims to predict the probability of a recession in the next 12 months. This model is primarily based on information derived from the yield curve. The yield curve, by analyzing the spreads in the bond market, serves as an indicator of liquidity conditions within the financial system.

• High Model Levels: When the Fed's recession model shows elevated levels, it signifies tight liquidity conditions. Historically, these periods of tight liquidity have systematically preceded economic recessions.
• Low Model Levels: Conversely, low levels in the model indicate loose liquidity conditions, which are typically observed outside of economic recessions, during periods of economic stability or booms.
• Typical Pattern: The usual pattern observed is that liquidity tightens before an economic downturn, leading to a recession. Following the recession, liquidity loosens up, ushering in a period of economic stability.

Contradictory Signals and the Role of Unemployment

A key point of discussion is the current divergence between economic data and the Fed's recession model.

• Recessionary Economic Data: The transcript highlights several concerning economic indicators:
  • The ADP job report turned negative for the first time since the pandemic.
  • The non-farm payroll report indicated the lowest number of jobs added since the pandemic, comparable to pre-Great Financial Crisis and pre-2001 recession levels.
  • The US unemployment rate has risen by nearly a full percentage point over the last 1.5 years, a rise not seen outside of recessions.
  • Federal Reserve Chair Jerome Powell has acknowledged the rising risk of recession due to these job market trends.
• Fed's Recession Model Signal: Despite this negative data, the Fed's recession model has recently shown a decrease in recession probability. This is unusual because the model typically declines after a recession has ended and liquidity has loosened.
• The Anomaly: The transcript notes that the model spiked to high levels in 2023-2024, indicating tight liquidity, but a recession did not materialize as expected. Now, the model is declining, which theoretically suggests a move towards economic stability. However, the validity of this signal is questioned due to the absence of a recession following the prior liquidity tightening.

Integrating Unemployment Data with the Fed's Model

To reconcile these conflicting signals, the transcript suggests incorporating the unemployment rate into the analysis.

• Liquidity Tightening and Unemployment: The analysis shows a strong correlation: every time liquidity dries up (as indicated by the Fed's model), it is shortly followed by a rise in the unemployment rate, which coincides with economic recessions.
• Current Situation: The liquidity tightening in 2023-2024 did indeed lead to a substantial rise in the unemployment rate, aligning with the expectation of being on the brink of a recession.
• Forward-Looking Analysis: When the Fed's recession probability model is shifted forward by approximately one year, its peaks align with the peaks in the unemployment rate. This implies that:
  • When liquidity tightens, the unemployment rate tends to rise over the following year.
  • When liquidity loosens, the unemployment rate tends to fall over the following year.
• Current Implication: Based on this, the Fed's current recession probability model suggests that the unemployment rate is peaking. This supports the argument that, despite current negative conditions, there might be a temporary improvement in the economy due to the loosening of liquidity.

Nuances and Lingering Tightness

Despite the potential for temporary improvement, the analysis emphasizes that the economic situation is not entirely positive.

• Elevated Recession Probability: The Fed's recession probability model, while declining, is still hovering around 30%. This is considered extremely high compared to the near-zero levels typically seen after actual recessions.
• Not Truly Loose Liquidity: This means that while liquidity conditions have loosened, they are not by any means loose.
• Bank Lending Standards: Data from a Federal Reserve survey on domestic banks' lending standards to corporations provides further evidence.
  • Historical Correlation: This survey has a good track record of anticipating recessions, with banks tightening lending in the months leading up to recessions (e.g., 1990, 2001, 2008).
  • Post-Recession Loosening: After recessions, banks typically loosen their lending standards significantly, with the survey dipping below zero.
  • Current Bank Behavior: The survey indicates that banks are still at high levels of tightening their lending standards. They are not loosening them, which is a crucial indicator.
• Combined Outlook: When the unemployment rate is considered alongside the forward-shifted lending standards survey, a clear pattern emerges: the banking system's tightness predicts the job market's trajectory. Since the survey remains at high levels, it suggests that domestic banks are not loosening their standards.

Economic Outlook and Investment Strategy

The combined analysis leads to a nuanced economic forecast.

• No Substantial Unemployment Rise: The expectation is that the unemployment rate will not rise substantially in the coming months.
• No Extended Prosperity: However, an extended period of prosperity with a plummeting unemployment rate is also not anticipated.
• Likely Scenario: The most probable scenario is a continuation of a struggling economic environment over the next year.
• Stock Market Implications: This environment has been favorable for the stock market. The current price action of the S&P 500 is seen as pointing to additional upside in the coming months, despite potential short-term volatility.
• Trading Strategy: The video mentions a trading strategy that aims to profit from both upward market movements (by being exposed to strong stocks) and protect against downturns. Examples of successful trades mentioned include Zcaler, Applied Materials, and Netera, PWR, which yielded double-digit gains. The strategy involves booking profits on some positions while remaining aggressively long on the market.

Conclusion

The US Federal Reserve's recession model, based on yield curve dynamics, is signaling a potential shift. While the model's decline suggests loosening liquidity and a potential peak in the unemployment rate, this is tempered by the fact that the model's probability remains elevated and bank lending standards are still tight. The most likely economic outlook is a continuation of a struggling environment rather than a sharp downturn or a robust recovery. This environment, however, has presented opportunities for stock market gains, with a strategy focused on capitalizing on upward trends while mitigating downside risk.