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A new way of measuring recession risk

Looking at the term spread, or difference in long- and short-term yield curves, is a common method of predicting when a recession is on the horizon. But an article in the BIS Quarterly Review examines how other types of financial cycle data can provide information that's just as valuable, if not more, for predicting economic downturns.

Term spread usually refers to an inverted yield curve, where long-term bond yields are below short-term interest rates. This indicator is often considered one of the best signals of an impeding recession. But the BIS authors argue that financial cycle proxies can provide valuable information and even give a more accurate indicator that a recession is on the horizon.

The article states: “For advanced economies, we find that financial cycle proxies provide valuable information for a horizon of up to three years, outperforming the term spread.” It also states that “the financial cycle proxies and the term spread seem to provide complementary information”.

Proxy indicators linked to financial cycles include:

  • medium-term fluctuations in credit and property prices; and
  • debt service ratio, defined as interest payments plus amortisation divided by GDP.

The article points out that business cycles and financial cycles are not necessarily synchronised, particular as the length of a financial cycle has increased in the past 40 years. “Business cycles as traditionally measured tend to last up to eight years, and financial cycles around 15 to 20 years since the early 1980s. The difference in length means that a financial cycle can span more than one business cycle. As a result, while financial cycle peaks tend to usher in recessions, not all recessions will be preceded by financial cycle peaks.”

By referencing a wider range of data in the calculation of recession probability, the authors also acknowledge the changing nature of recessions, which they say could be described as a “shift from inflation-induced to financial cycle-induced recessions”.

The article concludes: “These results suggest that financial cycle proxies may be another indicator that could be useful to policymakers, professional forecasters and market participants more generally.”

CTMfile take: This article provides some valuable food for thought for those involved in financial risk assessments.

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