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Part I: A New Toolkit to Predict Soft-Landings, Stagflation and Recessions

Summary

• In this first part of a series of reports, we introduce a new toolkit to predict the probability of soft-landing, stagflation and recessionary episodes.
• Bernanke (2024) reviewed the Bank of England's forecasting process for monetary policymaking, concentrating on the Bank's forecasting and decision-making during times of significant uncertainty. Bernanke outlined some recommendations to design effective policy decisions, placing emphasis on accurately identifying and quantifying risks to the outlook.
• We believe our proposed new framework would help decision makers effectively quantify potential risks to the economic outlook by moving away from the traditional approach of just forecasting recession probability and/or GDP growth rate predictions for the near future.
• The recent monetary policy path has been different from both the recession and the soft-landing projections of 2023, emphasizing the importance of not just concentrating on recession and soft-landing scenarios to forecast policy decisions.
• The toolkit helps analysts identify (a) whether the next phase is a soft-landing, (b) if stagflation is in the near-term picture and (c) whether a recession is coming.
• This report sets the stage by showing why the three economic outlook scenarios are important for monetary policy decisions, particularly in gauging the potential pace of the upcoming easing cycle.
• In the next installment of this series, we quantify historical episodes of soft-landings, stagflation and recessions.

Setting the Stage: A New Toolkit to Quantify Potential Risks to the Economic Outlook

Bernanke (2024) reviewed the Bank of England's forecast process for monetary policymaking, concentrating on the Bank's forecasting and decision-making during times of significant uncertainty, such as in the early years of the post-pandemic era.1 Central bankers around the globe, including in the U.S. and U.K., were challenged by higher inflation and volatile growth rates. For the most advanced economies, the post-pandemic era's higher inflation and volatile growth was, to some extent, different from the post-Great Recession period of muted economic growth and lack of inflation. Naturally, the post-pandemic era requires some new tools to help decision-making. In his review, Bernanke outlined some recommendations to design effective policy decisions, placing emphasis on accurately identifying and quantifying risks to the outlook.

We propose a new framework that would help decision makers effectively quantify potential risks to the economic outlook by moving away from the traditional approach of just forecasting recession probability and/or GDP growth rate predictions for the near future. We suggest characterizing the growth outlook into three different regimes, each of which are structurally different and would require different policy stances. This approach helps decision makers identify (a) whether the next phase is a soft-landing, (b) if stagflation is in the near-term picture and (c) whether a recession is coming. Moreover, the framework would help analysts project when it would be appropriate to (1) expect contractionary policies to fight higher inflation (higher probabilities of stagflation), (2) foresee policy normalization (higher probabilities of soft-landing) or (3) look for the start of expansionary policies (typically during a recession).

We readily acknowledge that, in some ways, predicting the probability of recession may be similar to forecasting the GDP growth rate; however, recession and stagflation predictions help to identify some potential risks to policy decisions. Historically, fighting stagflation is more challenging and may require a different policy path than recessions. For example, the Federal Open Market Committee (FOMC) reduced the fed funds rate in the last four recessions, but raised the fed funds rate to fight inflation in the 1980s stagflation/recessionary episode.

The current cycle stresses the importance of our proposed framework to generate the probabilities of the three suggested scenarios. For example, the past few years have noted talks of recession, stagflation and soft-landing. Members of the FOMC have been busy fighting higher inflation, volatile GDP growth rates and financial market participants' worries about recession and stagflation. Initially, the FOMC characterized the inflation seen after the pandemic as "transitory." When it turned out to be persistent, stagflation fears were raised, especially in the first half of 2022 which saw high inflation levels and negative GDP growth rates. To fight this decades-high inflation, the FOMC enacted the fastest rate hikes in decades. In response to the rapid rate hikes, analysts then predicted a recession. However, the U.S. economy proved resilient and has avoided a recession as of Q2–2024.

In summary, generating a forecast for the GDP growth rate and/or the probability of a recession during the next two quarters is not sufficient. For effective decision-making, it would be better to estimate the probabilities of each scenario (for example, a 30% chance of recession, 50% probability of soft-landing and 20% chance of stagflation). This would provide better information for decision makers who are setting policies for the future path of the economy.

Why is Predicting Recessions Not Enough?

During the 1990s, researchers started forecasting recession probabilities using logit/probit models.2 Recession probability forecasting has turned out to be useful as it helps decision makers by signaling recessions in advance. However, during the past three business cycles—each with the common theme of weaker recoveries—monetary policy stances were expansionary well after the official ending dates of recessions.

Most analysts rely on the NBER recession dates to build models that generate recession probabilities. The NBER employs several variables including GDP, employment and personal income to determine the start and end dates of a recession.3 Since most macroeconomic data are released with a time lag and are prone to revisions, the NBER announcements regarding a recession have start/end date lags. For example, on July 19, 2021, the NBER declared that the 2020 pandemic-era recession ended in April 2020. This announcement came over a year after the official recession end date.

However, monetary policy stances are typically set using near-term forecasts for the economy alongside historical data. That is, a recession forecast for the near-term would play a crucial role in policy decisions, all else equal. For example, most private sector forecasters were predicting a recession back in 2023, as shown in Table 1. Following the "technical recession" definition of two consecutive quarters of negative GDP growth, in April 2023, 40 out of 58 forecasters called for a recession to start some time in 2023. In May 2023, forecasts for a recession peaked, with 74.2% of forecasters expecting a recession.

The private sector forecasters were also calling for an accommodative monetary policy stance similar to that which occurred during the past four recessions in which the Fed reduced the fed funds rate. In May 2023, the Blue Chip Financial survey expected the upper bound of the fed funds rate to peak in Q3–2023 at 5.25%, followed by a rate cut of 25 bps in December 2023. Furthermore, the Blue Chip consensus predicted four more rate cuts in 2024, with the fed funds rate ending at 4.00% by Q4–2024. In other words, a recession prediction was associated with an accommodative policy stance where the FOMC would start reducing the fed funds rate in December 2023.

Why Has the Recent Monetary Policy Path Been Different From the Soft-Landing Projections?

While private sector forecasters expected a recession, most members of the FOMC were predicting a soft-landing. In 2023, the June Summary of Economic Projections (SEP) had a median estimate of 1.0% in 2023 and 1.1% in 2024 for real GDP growth and 5.6% in 2023 and 4.6% in 2024 for the fed funds rate. It is important to note that in June 2023, the fed funds rate was 5.25% and the FOMC expected two more 25 bps rate hikes. This is consistent with a soft-landing prediction—the FOMC expected policy normalization to start sometime in 2024, as the fed funds rate was 100 bps lower (at 4.60%) than the suggested 2023 year-end rate of 5.60%.

Therefore, two different forecasts—recession vs. soft-landing—were predicting somewhat different paths for the fed funds rate. The private sector's recession forecast was attached to an accommodative policy stance with rate cuts starting in 2023, while the FOMC's soft-landing projections were suggesting more rate hikes in the second half of 2023 along with four 25 bps rate cuts in 2024 (according to the June 2023 SEP).

However, the realized path of the fed funds rates has been different from both the recession and soft-landing calls of 2023. The dual mandate of the FOMC is to foster maximum employment and price stability. However, as stated above, the NBER heavily relies on measures of output, employment and consumption to determine the start and end dates of a recession. Essentially, both the NBER's approach and the theoretical definition of a soft-landing do not explicitly target inflation, even though inflation is part of the FOMC's dual mandate.

Our recent work relies heavily on measures of inflation and output to characterize stagflation into mild, moderate and severe episodes, complimenting the NBER's approach.4 It is important for our framework to capture major risks to the economic outlook in order to accurately predict policy stances.

The realized economic state turned out to be somewhat correlated with our framework of stagflation. Although FOMC members never explicitly acknowledged the risk of stagflation for the current cycle, their changing projections in the SEP are consistent with a stagflation risk. The June 2023 SEP projection of a soft-landing materialized into the actual economic state as of Q2–2024. However, the same SEP forecasted four rate cuts in 2024, and the FOMC has yet to cut this year. In fact, the most recent SEP in June 2024 suggested only one rate cut for the year.

The Upcoming Easing Cycle: Historians (Not History) May Repeat Themselves

In summary, recent years' recession and soft-landing calls were unable to accurately predict the fed funds path, so we should not be looking for a traditional easing cycle. A rate cut at the September meeting is a more likely–than–not scenario, and analysts are gauging the potential duration and magnitude of the easing cycle. As evident in the current cycle, we think concentrating on one risk is short-sighted and that approach would be ineffective to accurately capture the path of the fed funds rate. Instead of expecting a repeat in the last four recessionary experiences in which the FOMC enacted rapid rate cuts, our proposal quantifies the economic outlook into the three scenarios to effectively capture potential risks to the economic outlook. The next report quantifies historical episodes of soft-landings, stagflation and recessions for the post-1950 period. Stay tuned!

Endnotes

1 – Bernanke, Ben. "Forecasting for Monetary Policy Making and Communication at the Bank of England: A Review." Bank of England. April 12, 2024. (Return)

2 – Iqbal, Azhar and Nicole Cervi. "The Smoke Signal is Still Burning: Is Recession Coming?" Wells Fargo Economics. March 21, 2023. (Return)

3 – For more detail about the NBER recession dates, please see the NBER website. (Return).

4 – Iqbal, Azhar, Nicole Cervi and Delaney Conner. "Worst of Both Worlds: Are the Risks of Stagflation Elevated?" Wells Fargo Economics. April 17, 2024. (Return)

• USD/CAD found support ahead of Canadian employment data release.
• Positive US jobless claims data boosted sentiment and USD.
• Bank of Canada hopes for moderation in unemployment rate following 50 basis points of cuts.

USD/CAD seems to have found support ahead of crucial employment data set for release tomorrow.

The Canadian economy, particularly its job market, has struggled more than its counterparts, prompting the Bank of Canada (BoC) to lead in the rate cut cycle.

This week, the Canadian Dollar has benefited from a weaker US Dollar and a rebound in oil prices. Additionally, a surprisingly positive trade balance report, which comfortably beat estimates, has provided a further boost.

The Bank of Canada is facing more challenges than many of its peers. The economy’s performance has been lackluster, and with increasing discussions about a global recession, the Central Bank’s task becomes even more complex.

There was a positive today in terms of recessionary fears as US jobless claims came in better than expected. The number of unemployment benefit claims in the US dropped by 17,000 to 230,000 for the period ending August 3rd, falling short of market expectations of 240,000. Despite this decrease, the claim count remains significantly above this year’s average, suggesting that while the US labor market is still historically tight, it has softened from its post-pandemic peak.

Source: US Department of Labor

The data boosted sentiment, leading to a rise in US equities and an overall improvement in market outlook. The US Dollar index also gained traction and continues its upward trend following the selloff driven by recession fears on Friday and Monday.

Canadian Employment Data Ahead

Tomorrow will see the release of Canadian unemployment and employment change statistics. Since January, the unemployment rate has been declining, with a brief pause at 6.1% in March and April, before rising to 6.4% in June.

The Bank of Canada will be hoping for a moderation in the unemployment rate following the 50 basis points of cuts already implemented. A positive outcome might be what USD/CAD needs to break the key support level at 1.3736.

Technical Analysis

From a technical perspective, USD/CAD is positioned just above a critical support level at the 1.3736 mark. After failing to sustain levels above 1.3900, my earlier article this week mentioned the 1.3740-30 range as a potential area of interest for a retest.

Analyzing price action and today’s daily candle close could be pivotal. The positive jobs data print helped lift USD/CAD from its support, with the daily candle oscillating between a doji and a hammer pattern. Nevertheless, this could change by the end of the day.

Immediate support is at 1.3736, and a drop below this could lead to a retest of the 1.3690 area, which is also aligned with the 100-day moving average. On the upside, immediate resistance is at 1.3800, followed by levels at 1.3850 and 1.3900.

USD/CAD Chart, August 8, 2024

Source: TradingView (click to enlarge)

Support

• 1.3736
• 1.3690
• 1.3650

Resistance

• 1.3800
• 1.3855
• 1.3900

AUDUSD regained strength and advanced on Thursday, offsetting negative impact from Wednesday’s strong upside rejection under the base of rising daily cloud.

Several signals point to basing attempts and formation of reversal pattern on daily chart, such as Monday’s Hammer candle with long tail and a bear-trap.

Hammer is also forming on weekly chart, while long-tailed monthly Doji adds to signals that bears are losing traction.

Daily studies are mixed (momentum indicator is in negative territory and MA’s in bearish setup), but thinning and rising daily cloud attracts.

Break of 0.6573 (50% retracement of 0.6796/0.6348/daily Kijun-sen) is needed to boost positive signal for retest of cloud base (0.6599) and attack at Fibo 61.8% (0.66626).

Holding above broken 10DMA (0.6526) is minimum requirement to keep near-term bulls in play.

Res: 0.6573; 0.6592; 0.6601; 0.6626.
Sup: 0.6526; 0.6507; 0.6472; 0.6455.

The Australian dollar has had a busy week and is showing strong gains on Thursday. In the European session, AUD/USD is trading at 0.6550, up 0.50% at the time of writing.

RBA’s Bullock says rate hikes still on table

Two days after the Reserve Bank of Australia held the cash rate, Governor Bullock reinforced her hawkish stance on monetary policy. At the meeting, Bullock dropped a bombshell, saying she didn’t expect a rate cut for at least the next six months.

Bullock said earlier today that the central bank wouldn’t hesitate to raise rates if needed, arguing that “the alternative of persistently high inflation is worse”. The RBA discussed the possibility of a rate hike at recent meetings and today Bullock said the RBA board had “explicitly considered” a rate hike at Tuesday’s meeting. The Australian dollar has responded with strong gains to Bullock’s hawkish remarks.

At the Tuesday meeting, the central bank opted to maintain rates at the 12-year high of 4.35% for a seventh straight time. At a time when other major central banks have lowered rates and the mighty Federal Reserve is poised to make an initial cut in September, the RBA could well move in the opposite direction.

The blame can be squarely put on inflation, which remains sticky, especially services prices. The RBA is projecting that CPI, which rose to 3.9% in the second quarter, won’t recede to 2-3% target until late 2025. The labor market continues to remain tight to the large-scale immigration, which will also make it difficult for the RBA to reduce rates.

The financial markets are not marching to Bullock’s hawkish tune and widely expect a rate cut in December. The RBA has a poor track record with its forward guidance, particularly when it pledged in 2020 not to raise rates until 2023 and then hiked in May 2022. As well, the trend among central banks has been to lower rates and the RBA risks becoming an outlier if its raises rates.

AUD/USD Technical

• AUD/USD pushed above resistance at 0.6520 and tested resistance at 0.6559 earlier
• 0.6471 and 0.6432 are the next support levels

• Monday, 5 August significant sell-off in the Nikkei 225 has triggered a potential bullish key reversal inflection week.
• Citigroup Economic Surprise Index for Japan staged a positive turnaround on Monday, 5 August which suggests an improvement in macro data.
• The percentage of Nikkei 225 component stocks trading above their respective 200-day moving averages has reached an extremely low level; a potential capitulation of bearish pressure.
• Watch the 30,460 major key support on the Nikkei 225

Since our last publication, the price actions of Japan’s Nikkei 225 have managed to stage the expected rally and hit a fresh all-time of 42,427 on 11 July 2024, just below the lower limit of 42,600/43,400 medium-term resistance zone.

In the recent two weeks, the Nikkei 225 has succumbed to significant waves of bearish pressure due to a concoction of adverse events; especially via systemic funds flow positioning that led to a disruptive unwinding of risk-on-carry trade strategies.

On Monday, 5 August, the Nikkei 225 plummeted by 12.40%; its worst daily performance since October 1987 “Black Monday” crash. Also, its current 4-week max drawdown (highest to lowest) from the week of 8 July to 13 August stands at -26.60%, its worst 4-week drawdown since the outburst of the Covid-19 pandemic where it shed -31.30% from the week of 17 February 2020 to 16 March 2020.

Interestingly, 3 factors suggest that the climatic sell-off seen on Monday may have triggered a key bullish reversal inflection point for the Nikkei 225.

Fundamentals have improved in Japan

Fig 1: Japan Citigroup Economic Surprise Index as of 5 Aug 2024 (Source: MacroMicro, click to enlarge chart)

The Citigroup Economic Surprise Index (ESI) for Japan has rebounded back to a positive level of 1.60 as of Monday, 5 August after it dipped and remained in negative territory since 16 July (see Fig 1).

The ESI is the sum of the difference between the actual value of various economic data and their consensus forecasts. If the Index is greater than zero, it means that the actual values of these economic data on the aggregate are generally better than expected.

Hence a turnaround of the ESI from negative to positive is considered a potential catalyst to support a strengthening of the Nikkei 225.

Nikkei 225 component stocks above 200-day moving averages hit an extremely low condition

Fig 2: Percent of Nikkei 225 component stocks above 200-day MA as of 8 Aug 2024 (Source: MacroMicro, click to enlarge chart)

Monday, 5 August bloodbath impacted almost all sectors and stocks in the Nikkei 225 as the percentage of its component stocks above their respective 200-day moving averages torpedoed to a low level of 8.44% (see Fig 2).

The current reading of 8.44% is its 8th-lowest level in the past 24 years; prior extreme low levels were recorded in March 2020 (1.33%), March 2009 (2.22%), October 2008 (1.71%), March 2008 (4.46%), January 2008 (3.14%), February 2002 (5.36%), and December 2001 (7.69%).

Also, such extremely low levels have coincided with prior bullish reversal inflection zones for the Nikkei 225.

Therefore, the current 8.44% level of Nikkei 225 component stocks that are trading above 200-day moving averages can be considered as an extreme bearish sentiment outlier, and from a contrary opinion perspective such behaviour may indicate a capitulation of the bearish pressure.

JGB yield curves are still in steepening mode

Fig 3: JGB yield curves major trends as of 8 Aug 2024 (Source: TradingView, click to enlarge chart)

Since June 2022, the steepening of the Japanese Government Bond (JGB) yield curves, both the 10-year minus 2-year and 30-year minus 2-year have moved in direct tandem with the major uptrend phase of the Nikkei 225 (see Fig 3).

The past four weeks of push-down in the JGB yield spreads have started to stage bounces at their respective key medium-term support levels; 0.53% (10-year minus 2-year), and 1.66% (30-year minus 2-year).

Therefore, this set of intermarket dynamics from the potential continuation of the steepening of the JGB yield curves may lead to a positive movement in the Nikkei 225.

Watch the 30,460 major key support on the Nikkei 225

Fig 4: Nikkei 225 major trend as of 8 Aug 2024 (Source: TradingView, click to enlarge chart)

The current price actions of the Nikkei 225 have started to shape an impending weekly bullish reversal “Hammer” candlestick pattern; considered a bullish key reversal week in the lens of technical analysis.

A clearance above 37,070 medium-term resistance (also the 200-day moving average) increases the odds of a medium-term recovery for the next medium-term resistance zone to come in at 42,600/43,400 (see Fig 4).

However, a weekly close below 30,460 long-term pivotal support invalidates the recovery scenario to kick start a potential multi-month corrective decline phase to expose the next major support at 25,770 in the first step.

Gold regained traction and bounced on Thursday, following a sharp fall in past few days.

Fresh strength signals that the situation is stabilizing after a turbulent period and broader bulls are about to re-take control.

The yellow metal benefited from growing signals that the Fed will start cutting interest rates as from September, with US policy easing cycle about to start and deteriorating conditions of the US economy, fueling speculations about stronger than expected initial rate cut (0.5% vs 0.25%).

Economic slowdown and growing US debt concerns are likely to continue to boost gold price, contributing to overall bullish picture.

Technical picture on daily chart is firming, as momentum emerges into positive territory and RSI turns north above neutrality zone, with close above pivots at $2407/14 (Fibo 38.2% of $2477/$2364 / 20DMA) to boost positive signals and open way for further recovery.

Near-term action is expected to remain biased higher while holding above psychological $2400 level.

Res: 2414; 2420; 2434; 2450.
Sup: 2400; 2391; 2379; 2364.

Daily Pivots: (S1) 144.69; (P) 146.30; (R1) 148.31; More...

Intraday bias in USD/JPY remains neutral for the moment. While further rise cannot be ruled out, outlook will stay bearish as long as 150.88 resistance holds. On the downside, below 144.04 minor support will bring retest of 141.67 first. Break there will resume the fall from 161.94 to 140.25 support next.

In the bigger picture, the strong break of 55 W EMA (now at 149.98) argue that fall from 161.94 medium term is correcting whole up trend from 102.58 (2021 low). Deeper decline could be seen to 38.2% retracement of 102.58 to 161.94 at 139.26, which is close to 140.25 support. In any case, risk will stay on the downside as long as 55 W EMA (now at 149.83) holds. Nevertheless, firm break of 55 W EMA will suggest that the range for medium term corrective pattern is already set.

Daily Pivots: (S1) 0.8530; (P) 0.8596; (R1) 0.8683; More…

Intraday bias in USD/CHF remains neutral and outlook is unchanged. While recovery from 0.8431 might extend, further decline is expected with 0.8711 resistance intact. On the downside, below 0.8500 will bring retest of 0.8431 first. Break there will resume the fall from 0.9223 to retest 0.8332 low.

In the bigger picture, price actions from 0.8332 (2023 low) are currently seen as a medium term corrective pattern, with fall from 0.9223 as the second leg. Strong support could be seen from 0.8332 to bring rebound. Yet, overall outlook will continue to stay bearish as long as 0.9243 resistance holds. Firm break of 0.8332, however, will resume larger down trend from 1.0146 (2022 high).

Daily Pivots: (S1) 1.2669; (P) 1.2703; (R1) 1.2726; More...

Intraday bias in GBP/USD remains on the downside at this point. Fall from 1.3043 should continue to 1.2612 support. Decisive break there should confirm that rise from 1.2298 has completed, and target this support next. However, break of 1.2839 resistance will argue that the pull back from 1.3043 has completed and turn bias back to the upside.

In the bigger picture, current development suggests that corrective pattern from 1.3141 is extending with fall from 1.3043 as another leg. Break of 1.2612 support would strengthen this case. But still, downside should be contained by 1.2036/2298 support zone even in case of deep decline. Rise from 1.0351 (2022 low) remains in favor to resume at a later stage.

Daily Pivots: (S1) 1.0907; (P) 1.0922; (R1) 1.0938; More.....

EUR/USD dips mildly in early US session as consolidation from 1.1007 extends. Intraday bias remains neutral first. While deeper retreat cannot be ruled out, downside should be contained well above 1.0776 support. On the upside, above 1.0944 minor resistance will bring retest of 1.1007 first. Further break there will resume recent rally from 1.0665 to 100% projection of 1.0665 to 1.0947 from 1.0776 at 1.1056 next.

In the bigger picture, price actions from 1.1274 are viewed as a corrective pattern that's still be in progress. Break of 1.1138 resistance will be the first signal that rise from 0.9534 (2022 low) is ready to resume through 1.1274 (2023 high). However, break of 1.0776 support will extend the correction with another falling leg back towards 1.0447 support.