A FRBSF maco economic letter discusses the yield curve and recessions.

Please consider Information in the Yield Curve about Future Recessions.

Although the U.S. economy is in a sustained expansion and many economic indicators show continued strength, concerns about a possible recession have emerged. One reason is the narrowing spread between long-term and short-term Treasury yields. A well-established regularity in postwar U.S. economic history is that an inverted yield curve—when long-term rates drop below short-term rates—is generally followed shortly afterward by an economic recession.

Financial commentators typically focus on the difference between the ten-year and two-year Treasury yield (10y–2y), because the former summarizes long-term perceptions and sentiment of bond market investors, while the latter is viewed as a reasonable indicator of the stance of monetary policy. But many other combinations of long-term and short-term yields are possible. The tradition in the academic literature has been to focus on the spread between the ten-year and three-month Treasury yields (10y–3m), going back to Estrella and Mishkin (1998), who documented the strong predictive power of this term spread for recessions and economic activity. Recently, Engstrom and Sharpe (2018) have argued that a spread of short-term Treasury rates—the difference between the six-quarters-ahead forward rate and the three-month yield (forward6q–3m)—might be preferable as a predictor because it focuses on expectations of the near-term path of monetary policy.

Term Spreads vs Recessions

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