What a Little Liquidity'll Do For You

Since we last looked at the Federal Reserve's actions, the Fed injected well over 38 billion USD of liquidity into the economy to ensure that credit markets would not dry up for a lack of money. We thought we'd look at what that means for the probability of recession in the United States.

The chart below shows what happened last week to the U.S. Treasury Yield Curve:

The chart above shows that a major reversion has taken place. On Monday, prior to the Fed's actions of last week, the yield curve was essentially flat, with just 0.04% difference between the 10-Year and the 3-Month Treasuries. However, by Friday, the market's reaction to the Fed's moves greatly reduced the yield of the short term Treasuries. This change sharply reduced the probability of recession occurring in the U.S over the next 12 months, as can be seen by its retreat away from the 50% probability level in our chart for visualizing the probability of recession:

The chart above shows the daily snapshots for Monday, August 13 and Friday, August 17, 2007 given the values of the 3-Month, 10-Year and Federal Funds Rate for those days, rather than the 1-quarter rolling average of each. We find that the probability of recession occurring in the next 12 months from these daily snapshots plummeted from 34% to 15% from Monday to Friday.

We expect that the markets have a lot of shaking out to do still before the yield curve settles down, and there is also an increased likelihood that the Fed may lower the Federal Funds Rate, which will also affect the actual probability of recession.