- We believe that the technical recession definition (two quarters of negative growth) should be replaced with a more holistic one. In our view, a recession is a decline in economic activity, significantly below potential, impacting many sectors, and lasting longer than a few months. Our recession probabilities are broadly based on this holistic approach and not the two quarters of negative growth approach.
- The risk of recession in Canada has increased over the last few months. Our new recession risk tracker shows that there is a 70 per cent chance that Canada will enter a recession within the next 12 months.
- What happens south of the border also matters for us. We are estimating a 75 per cent chance of a recession in the U.S. within the next 12 months—recession risk in the U.S. peaked at 80 per cent in July and has been slowly declining since.
- In our risk model, we incorporate indicators such as Canadian and U.S. yield curves (10-year minus 3-month), U.S. excess bond premiums, and crude oil prices.
- The slope of the Canadian yield curve was –0.47 bps in September, while the slope of the U.S. yield curve was 0.5 bps. U.S. excess bond premiums rose to 0.04 bps after two months of decline. The average price of Western Texas Crude Oil declined for a third consecutive month, falling to $84.3 USD per barrel.
- Inflation is easing but at the cost of higher interest rates. Consumer spending growth has decelerated, and consumer confidence has dampened. But there are bright spots in the Canadian economy, such as a still-low unemployment rate and a strong services sector, which are pushing against a recession.
Investor sentiment has declined in Canada. The most recent data show that the yield curve inverted in August and declined further in September. An inverted yield curve means that the short-term government bond yield is greater than the long-term government bond yield. This signals that the market outlook is negative. Historically, yield curve inversions have preceded recessionary periods. However, this does not necessarily indicate that a recession is on the cards. There have been instances when the yield curve inverted but recessions were avoided. What the inversion of the yield curve tells us is that investor sentiment has dampened, and the risk of recession has intensified.
The U.S. yield curve (10-year minus 3-month) has yet to invert, meaning that investors are less skeptical in the U.S. compared to Canada. The U.S. yield curve has flattened in recent months, and this has added to the risk of recession in the U.S. Other measures, such as the 10-year minus 2-year, inverted in July and have declined since. Excess bond premiums rose in the U.S. last month. This means that investors are likely willing to take on riskier assets in the corporate bond market. However, this may lead to higher rates of default which could trigger a recession. With the Canadian and U.S. economies being closely linked, and with U.S. recessions (historically) preceding Canadian recessions, the risks in the U.S. can certainly spill over into Canada.
Our most recent forecast does not call for a technical recession. But it is important to distinguish the results of our recession risk model from the results of our forecast. Our recession risk model measures the risk of recession in Canada within the next 12 months by examining current market sentiment—not taking future policy changes into account. The risk of recession is high, but if there is a recession, it will be a mild one, since the Bank of Canada will stop raising rates well before inflation gets anywhere close to its upper target limit of 3 per cent. The Bank of Canada will be successful in lowering inflation from its recent levels, but it will happen at the price of stagnant growth until Spring 2023. Still, if the Bank raises rates too quickly and aggressively to bring inflation within its target range, then it could potentially drive the economy into a deep recession. And if it does, a recession will happen much sooner than inflation going under 3 per cent.