Economic Forecasting Methods

The US yield curve is sending a crucial signal here. The chart shows how all post gold standard recessions (shaded in orange) have been anticipated by the following pattern: yield curve inversion (2s10s in blue), time lag, steepening, recession. This is exactly the pattern we have followed since June 2022 – but why does it work this way? Yield curve inversions signal monetary policy is too tight: companies and households face harsher credit conditions and hence cut their borrowing activities – with a (variable) time lag the economy slows down. At this point the yield curve steepens. That’s either because the economy or markets broke: the Fed must cut rates fast = bull steepening (2008). Or because it’s taking too long and a ‘’this time is different’’ narrative forces higher term premium and even harsher credit conditions late cycle until eventually breaking something = bear steepening (1980s, today). The inversion has now lasted for 16 months and as the dangerous late-cycle steepening is unfolding under our very eyes it could be beneficial to have a check with Dr. Yield Curve. The passage of time is a boring but crucial variable in this relationship: the longer the yield curve remains inverted the longer markets are signaling tight credit conditions for the private sector. That matters because a longer yield curve inversions means the tightening is getting transferred to a larger and larger proportion of corporates and households. The most recent example concerns the 2008-2009 GFC: the Fed hiked rates rapidly and went for a loooong pause in 2006 by keeping rates ‘’higher for longer’’ for several quarters. The yield curve inversion which started in early 2006 lasted for a long time hence spreading the tightening deeper into the US economy until it finally cracked the housing market and a severe recession unfolded. We are now at month number 16 of persistent yield curve inversion which is being followed by a playbook steepening. And it's the post-inversion steepening you should worry the most about. Interested in trying my institutional research? Send me an IB chat on BBG!

July’s employment report from the Bureau of Labor Statistics should give the Fed the exclamation point they have been looking for to show that the economy is slowing enough to warrant a rate cut. Market expectations have shifted firmly to a 50-bps interest rate cut at the Fed’s meeting in mid-September, rather than a 25-bps cut which had been the prevailing view prior to this report. Now handwringing will ratchet higher as to whether the Fed is in the process of successfully orchestrating a soft landing or if they have waited too long to shift their monetary policy stance. Job growth slowed more than expected in July and gains in May and June were revised lower. The unemployment rate increased 20 bps during the month and is up 60 bps over the past six months – unemployment rate changes of 50 bps or more over a six-month period have typically corresponded with recessions (see accompanying chart). Wage growth also appears to have slowed over the past couple of months. Even allowing for some volatility in the monthly data, the three-month moving average in employment growth and unemployment show an undeniable softening. Unemployment insurance claims add further evidence to the slowing trend. Initial unemployment claims have ticked higher over the past three weeks and continuing claims are at their highest level since the fourth quarter of 2021. It is difficult to call current labor market conditions weak with the unemployment rate still at 4.3%, but job gains appear increasingly lackluster across major employment sectors and the loss of momentum is undeniable. Stock and bond market participants are reacting in a way that suggests increased recession fears. Earnings reports have only fueled these concerns. The 10-year Treasury rate has fallen materially below 4.0%. Mortgage rates have also been ticking lower, which is good news for prospective home buyers. Rate cuts appear to be on the way, but macroeconomic conditions are increasingly precarious and the Fed’s September meeting may start to feel like a lifetime away if more bad news unfolds. The week ahead is not a busy one from an economic news perspective, but ISM services, mortgage delinquency, Fed Senior Loan Office Survey, and jobless claims, among others will be interesting to watch for additional information on the economy’s trajectory. What indicators are you watching for?

We continue to think market pricing for 4-5 cuts over the next three months, implying at least one 50 basis-point cut, is too dovish for a world where GDP is tracking close to 3% and inflation remains above target. Indeed, 50 basis-point cuts typically happen in the context of spiking unemployment and/or sharply wider credit spreads, neither of which were seeing today. The chart below shows that the most recent environments where the Fed cut 50 basis points at meetings were hard landing environments including 1990-91, 2001, and 2008, which were quite different relative to the “rolling sector contractions and expansions” backdrop that we see today. Inflation is cooling slowly, but enough to allow the Fed to initiate a gradual series of cuts starting in September that we think will take policy rates towards long-run neutral levels (low-3% range) over the next year. Importantly, we at @KKR see notable tailwinds persisting in areas including productivity, consumer wealth, and AI-related investment. The S&P 500 may continue to chop as it digests elevated valuations and good-not-great earnings trends. That said, other areas of the market across smaller and private company valuations, credit, infrastructure, and real estate look much more attractive from a valuation perspective. Furthermore, a cutting cycle should help spur capital markets activity, and over time, revive sentiment in the more rate-sensitive areas of the economy and markets. Read more at https://go.kkr.com/3SOUm4Y

Today we have launched a new forecasting tool for predicting the #yield #curve. We have built a Dynamic Nelson and Siegel model, augmented with daily growth- and inflation-surprises. Based on an evaluation using historical data, the model improves forecast accuracy for the 2-year yield by as much as 24% (compared to consensus). Predictions for the 10-year yield see a smaller but also significant improvement. The model predicted the current levels of 2- and 10-year Treasury yields — 4.9% and 4.2%, respectively — in June 2022. That was nine months before professional forecasters surveyed by #Bloomberg raised their own predictions for the 2-year rate above 4.5%. You can find the live #Bloomberg #Economics #Macro-#Yield model as well as survey and contributor forecasts and consensus for US Treasury yields via BECO MODELS<GO> on the #Bloomberg #Terminal! Andrej Sokol Josh Danial Scott J. Bhargavi Sakthivel Ana Beatriz Galvao Martin Ademmer Owen Minde, CFA Mike Denicola Anna Wong

The MPC took another step towards rate cuts today with two members voting for a rate cut. What’s more, the minutes included new guidance that “the risks from inflation persistence were receding” and a lower inflation forecast. This lays the groundwork for the first rate cut to come in the summer. We think June is most likely but it wouldn't take much to push it back to August. We then think will be followed by two more cuts leaving interest rates at 4.5% by the end of the year and at least 4 cuts in 2025. As expected the MPC left bank rate unchanged at 5.2% today. But this was a dovish hold for three reasons. First, Deputy Governor Dave Ramsden joined Swati Dhingra in seeking a reduction in rates making it 7-2. (Ramsden has tended to be a bit ahead of the pack when it comes to changes in direction). Second, the committee added guidance that it will watch the “forthcoming data releases and how these informed the assessment that the risks from inflation persistence were receding.” We interpret this to mean that as long as there are no big upside surprises in the next few data releases, a rate cut will come sooner rather than later. Third, the Bank significantly reduced its inflation forecast. If interest rates follow the path that financial markets are now pricing in, inflation would be just 1.6% by the end of 2026 compared to a forecast of 2% made in March. This is a clear message to financial markets that they have gone too far in reigning in expectations for rate cuts. The upshot is that the Bank is clearly on its way to rate cuts, we think the change in guidance and forecasts are laying the groundwork for the first rate cut to come in summer, probably June but maybe August, it will depend on how the next two inflation and jobs reports turn out. At the very least, every meeting from now on should be considered live. #RSMUK #RealEconomy #MPC #InterestRates

As widely expected, the Fed kept rates unchanged at today’s meeting. The main event, however, was the release of new economic projections from FOMC participations, which sheds light on decisions in future meetings – and indicates the Fed remains vigilant against the threat of a renewed bout of high inflation. Some takeaways: ◾ The FOMC projection for Q4 2025 core PCE inflation rate (YoY) has risen to 3.1%, up from 2.8% previously. Chair Powell also stated tariffs are still “likely to push up prices,” an assessment we agree with. ◾ The FOMC projections for real GDP growth in Q4 2025 (YoY) dropped to 1.4% from 1.7%. But while the Fed assesses growth as slowing, it seems to view this primarily as a negative supply shock (from the tariffs). In principle, while the Fed should respond to a negative demand shock by easing monetary policy, that’s not the case for a negative supply shock. ◾ The median FOMC member continues to expect the federal-funds rate to be cut by 50 basis points in 2025 to a target range of 3.75-4.00%. But expectations for the federal-funds rate at year-end 2026 and 2027 have risen to 3.50-3.75% and 3.25-3.50% respectively, up by 25 basis points compared to the prior projections. ◾ Moreover, despite the unchanged median for 2025, 7 of 19 participants in the FOMC projections now expect no rate cut this year, up from 4 participants as of March. For now, Morningstar continues to expect two rate cuts this year. We expect the uncertainty engendered by the tariffs to constitute a significant negative demand shock, which will call for mild monetary policy easing despite an acceleration in inflation. In terms of the timing, however, it does now look more likely that the first cut will come in September, rather than July as we previously expected.

Chair Powell’s speech at Jackson Hole was enlightening, and we now have high conviction the #Fed will cut in September: The Fed’s reaction function is more dovish than we thought. Chair Powell acknowledged that shocks to both labor supply and demand pose real downside risks – especially given recent soft jobs data. This suggests the Fed is becoming more attuned to labor market fragility and may be quicker to act in response. This makes us more constructive about market outcomes in the near term. A modestly lower cost of capital directly improves borrower health, to the relief of public and private credit, and to the consumer. Cyclical sectors such as industrials and financials should also benefit from a relative curve steepening. We’ll outline more on our views here in Macro Pulse, coming Sept 2. … but we’d fade moves in lower quality segments / sectors. With valuations at record highs, we are invested but focused on earnings quality. Improvements in ‘low quality’ earnings or small caps are likely to be short lived unless we see clear signs that economic growth is accelerating. Since the Fed would be cutting in response to economic weakness, we don’t believe that’s where we are in the economic cycle. At this juncture, we’re still doubtful that a September cut points to a prolonged interest rate cutting cycle. Risks to inflation are real and coming from many angles (tariffs, corporate margin protection, a sharp falloff in labor market supply). What’s more, financial conditions are very loose, making it difficult to justify a rapid rate-cutting cycle in our view.

Do’s & Dots The Federal Reserve concludes its two-day meeting today, with markets virtually certain that rates will remain unchanged in the 4.25% - 4.50% range—marking the seventh consecutive month at this level. While the rate decision itself holds no surprises, traders are positioning for nuance. Bloomberg reports that savvy investors have taken long positions, anticipating Chair Powell will adopt a more dovish tone that signals future rate cuts. The real risk lies in the updated dot plot projections. A hawkish shift showing fewer anticipated cuts would likely disappoint both Fed watchers and markets, potentially triggering volatility despite the expected rate hold. Economic fundamentals suggest the Fed will eventually ease policy as growth moderates in the second half of 2025, down from the current 2% pace. The recession narrative has largely faded, with even previously bearish economists revising their outlooks upward. This shift reflects underlying economic resilience that has surprised many forecasters throughout the cycle. For the latter half of 2025, expect GDP growth to decelerate to a more sustainable 1% - 1.5% range—a pace that should provide the Fed with sufficient justification to begin cutting rates without signaling economic distress. When the Fed does resume its easing path, I expect: - Treasury rates to decline approximately 50 basis points over that year, with short-term yields leading the decline as the market prices in policy normalization. - Refinancing activity to accelerate across high-yield and broadly syndicated loan markets as credit spreads tighten and all-in borrowing costs fall. - Corporate earnings growth to initially slow alongside GDP deceleration, then recover modestly once Fed easing begins to support economic activity. - M&A activity to rebound significantly as companies that have been hoarding cash and preserving liquidity regain confidence to deploy capital. - Capital expenditure to increase meaningfully—a long-overdue development that's critically needed. - Housing market activity to strengthen as lower mortgage rates improve affordability and unlock pent-up demand. - Financial and technology sectors to outperform given their sensitivity to funding costs. - Credit market conditions to improve broadly, driving increased demand for private credit while reducing default risks across industry sectors.

S&OP, IBP, and S&OE are NOT the same. This infographic compares S&OP, IBP (integrated business planning), and S&OE (sales and operations execution): Key Focus ↳ S&OP: volume balancing across functions ↳ IBP: strategic alignment and financial integration ↳ S&OE: short-term execution and issue resolution Planning Inputs ↳ S&OP: forecasts + capacity + inventory + lead times + promotions + historical sales ↳ IBP: strategic plan + commercial plan + demand plan + supply plan + inventory plan + financial plan + scenario planning ↳ S&OE: confirmed orders + actual production + delivery schedules + real-time disruptions Planning Outputs ↳ S&OP: demand plan + supply plan + inventory plan ↳ IBP: aligned financial plans + operational plans + strategy execution ↳ S&OE: updated production schedule + fulfillment plan + logistics plans Challenges ↳ S&OP: functional silos, inconsistent data, lack of ownership ↳ IBP: complex alignment of financial and operational goals ↳ S&OE: firefighting, poor visibility, lack of short-term capacity flexibility Financial Integration ↳ S&OP: limited to top-line revenue and cost of goods sold (COGS) ↳ IBP: fully integrated with P&L, cash flow, and balance sheet ↳ S&OE: not typically integrated; advanced setups provide cash flow visibility Scenario Planning ↳ S&OP: moderate; volume-based what-ifs ↳ IBP: high; financial, strategic, market-driven scenarios ↳ S&OE: low; focused on immediate adjustments KPIs  ↳ S&OP: forecast accuracy, bias, inventory turns, service level, OTIF ↳ IBP: margin, revenue, working capital, EBITDA, EBIT ↳ S&OE: OTIF, order backlog, service level, schedule adherence, production attainment Any others to add?

“Let’s build a driver-based model” is often framed as a forecasting upgrade. It is more than that: It is a governance decision about who owns which assumptions, how planning processes connect, and what each number is actually meant to do. Many finance functions still run long-range planning, budgeting and rolling forecasts as separate exercises. Often in different tools. Sometimes owned by different teams. Then the organisation is surprised when the numbers do not align. All budget processes I've been a part of started in one of two places... - Last year's actuals and an extrapolation - The latest forecast for next year None took into account the company strategy, and as a result... ...it felt disconnected, was difficult to get buy-in for, and was outdated as soon as the new year started. That's why I now work with clients to do it differently... The logic that connects the processes is fairly simple: 1️⃣ Strategy vs. reality The long-range plan and annual budget are strategy-driven. They define where the business has chosen to go. The rolling forecast is reality-driven. It shows where the business is actually heading. 2️⃣ No gap between budget and plan The annual budget should not contradict the long-range plan. If it does, either the strategy or the budget needs to be challenged. 3️⃣ Budgeting is about closing the gap Budgeting is not about producing another version of the truth. It is about deciding which actions, resources and trade-offs are needed to close the gap between forecasted reality and strategic ambition. 4️⃣ Drivers belong to the business Volume, price, mix, headcount and capacity assumptions should be owned by the people who can actually influence them. Finance should not create business assumptions in isolation. 5️⃣ Finance owns the model, not all the inputs Finance should govern the model, connect the drivers and ensure consistency. The business should own the assumptions that go into it. Most planning disagreements are not really about the numbers. They are about unclear ownership, disconnected processes, or different definitions of what each number is supposed to represent. Where does your organisation draw the line between what Finance owns and what the business owns in planning? ♻️ Like, comment, and repost to help more finance teams ---------- 🧑🏼💼 I am a Partner at Implement Consulting Group 🗣️ Reach out to talk about the following: ...Finance Transformation ...Enterprise Performance Management ...Finance Capability Building ...Value Creation