US Recession Probabilities, Financial Stress Index STLFSI, Yield Curve indicators

There are many economic models to predict recessions and these models are primarily based on Business cycle variables, bond yields and yield spreads.In this post, lets look at a couple that are readily available on FRED website.

I. Smoothed U.S. Recession Probabilities

Smoothed recession probabilities for the United States are obtained from a dynamic-factor markov-switching model applied to four monthly coincident variables

  • non-farm payroll employment, 
  • the index of industrial production, 
  • real personal income excluding transfer payments, and 
  • real manufacturing and trade sales. 

This model was originally developed in Chauvet, M., “An Economic Characterization of Business Cycle Dynamics with Factor Structure and Regime Switching,” International Economic Review, 1998, 39, 969-996. (http://faculty.ucr.edu/~chauvet/ier.pdf

The same chart zoomed in for the recent 10 years.

II. St. Louis Fed Financial Stress Index (STLFSI)

The SLFSI reports with a one-week lag. This means that the reported values do not include last week’s market action. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. 

Jeff Miller’s blog “A dash of Insight” quotes “Before implementing this indicator our team did extensive research, discovering a “warning range” that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions. The STLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events.  It uses data, mostly from credit markets, to reach an objective risk assessment.  The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.”


The STLFSI measures the degree of financial stress in the markets and is constructed from 18 weekly data series: 

  • seven interest rate series,
  • six yield spreads and 
  • five other indicators. 

Each of these variables captures some aspect of financial stress. Accordingly, as the level of financial stress in the economy changes, the data series are likely to move together. The latest STLFSI press release, with commentary, can be found at http://www.stlouisfed.org/newsroom/financial-stress-index/ 

How to Interpret the Index 
The average value of the index, which begins in late 1993, is designed to be zero. Thus, zero is viewed as representing normal financial market conditions. Values below zero suggest below-average financial market stress, while values above zero suggest above-average financial market stress. 

More information 
For additional information on the STLFSI and its construction, see “Measuring Financial Market Stress” (http://research.stlouisfed.org/publications/es/10/ES1002.pdf) and the related appendix (http://research.stlouisfed.org/publications/net/NETJan2010Appendix.pdf). As of 07/15/2010 the Vanguard Financial Exchange-Traded Fund series has been replaced with the S&P 500 Financials Index. This change was made to facilitate a more timely and automated updating of the FSI. Switching from the Vanguard series to the S&P series produced no meaningful change in the index. 
Copyright Federal Reserve Bank of St. Louis.



Below is the STLFSI indicator for the past 5 years..





III. The Yield Curve as a Leading Indicator – NY Fed

http://www.newyorkfed.org/research/capital_markets/ycfaq.html

Be a prepared investor: www.thepreparedinvestor.com

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