Yahoo Finance What the market's 'fear index' says (and doesn't say) about a potential recession
Investors watching the market's "fear index" for signs of a recession need to be careful to "separate the noise from the signal," BMO economists say.
In a recent note, BMO economists Douglas Porter and Robert Kavcic observe that during last Monday’s deep market plunge, a measure of volatility called the VIX jumped to territory seen only 15 times in the last 30 years.
Although the last four U.S. recessions were preceded by such activity, they believe “the U.S. economy will manage to stay out of a full-blown recession,” even if the likelihood has increased slightly.
“The broad takeaway is that recessions have almost always been led by a major market dislocation,” they wrote. “But a major market dislocation doesn’t necessarily imply an imminent recession.”
The VIX is the Chicago Board Options Exchange (Cboe) Volatility Index, which uses fluctuations in S&P 500 index options prices to sketch market volatility. A very stable VIX is between 0 and 15, 15 to 25 suggests some minor volatility, and over 30 is considered highly volatile.
On August 5, when the S&P 500 dropped three per cent and the Nasdaq 3.4 per cent (after Japan's Nikkei index fell more than 12 per cent), the VIX crossed 60 around midday and closed over 38.
In their note, Porter and Kavcic looked at 10 major global or financial events over the last 30 years where the VIX was 38 or higher. In all of them, stock markets eventually fell more than 10 per cent (which didn't happen this time). In four of them (the first Persian Gulf war, 9/11, the 2008 global financial crisis and the 2020 COVID pandemic) a U.S. recession took place.
The current economic situation also includes U.S. unemployment numbers breaking the Sahm Rule, frequently an early predictor of recessions. But, the economists say, “even Sahm herself has somewhat disavowed the rule in this case, as there are so many unusual aspects to this cycle—including the low starting point for the jobless rate, the gradual nature of the rise, and relatively strong population growth in the past year.”
Similarly, Porter and Kavcic say the inverted yield curve, which shows higher interest on short-term government bonds than long-term bonds, “has been a fool-proof recession leading indicator for 50 years.” But they also say that, as with the Sahm Rule, “it is possible that ‘this time is different,’ owing to the unique nature of the current cycle.”
They note that some other markers, such as real GDP, retail and auto sales and industrial production, do not point to a recession. With all of these factors in mind, they say the U.S. is likely to avoid a recession, “assuming there are no major external shocks.” But, they write, “it is fair to conclude that recession risks have increased recently,” suggesting the odds of a recession in the next 12 months are about 35 per cent.
Porter and Kavcic make note of Canada’s softer economy and more extreme violation of the Sahm Rule on unemployment, but they say that “the Bank of Canada is a step ahead of the game” given it has already made two interest rate cuts this year.
“And just as the economy has suffered more due to its greater interest rate sensitivity, an easier monetary policy could have a much bigger punch in helping steer growth away from the recession shoals.”
John MacFarlane is a senior reporter at Yahoo Finance Canada. Follow him on Twitter @jmacf. Download the Yahoo Finance app, available for Apple and Android.
