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Reading Tea Leaves – Predicting Canadian Recessions Using Financial Variables February 5, 2008

Posted by DustinRJay in recession risks.
Tags: , , ,

One of the tools that the Bank of Canada uses for forecasting probability of recessions is the spread between Government of Canada 10 year bond yields and 90 day commercial paper.  This is a leading indicator of slower economic growth.  The benefit of using a tool like this, is that if recessions can be successfully predicted in advance, monetary policy can be adjusted accordingly.

The paper “Predicting Canadian Recessions Using Financial Variables: A Probit Approach” concludes to say:

“Results in the paper show that, in comparison to other financial variables, the spread between Canadian long bonds and the 90-day commercial paper rate is best at predicting recessions in Canada.”

The following graph shows that the spread has been the largest since the 1990’s recession for about a year:

Predicting Canadian Recessions Using Financial Variables

The past two recessions have marked peaks in the housing cycle in Calgary.  As carrying costs are the highest since previous housing bubbles (see this post), it is useful to estimate the probability of a recession as a tool in forecasting the peak in the current housing cycle. 

I am optimistic that Canada will avoid a recession at this point.  However, I estimate that the next period will be the slowest economic growth that has been seen in more than a decade.  I estimate that the probabilities of a Canadian recession are about the chance of flipping a coin three times and having all heads.  Currently,  Global Insight has estimated the probability of recession at 25% in Canada, with most other instutions forecasting less risk than that.

For those that are highly leveraged and unable to cope with an economic shock, there may be difficult times ahead…