As outlined in a previous post, the yield curve plots – for a given issuer or credit rating – the level of interest rates for different maturities. As was also mentioned, the yield curve and its shape indicate how investors in the bond market perceive the current and future state of the economy.

One of the most popular yield curves is the sovereign yield curve of the United States. This article will outline how the shape of the sovereign yield curve in the United States can be used to predict a future recession of the US economy.

At the end of this article, we will have defined two indicators that have the ability to provide recession signals based on the yield curve. As a signal is not immediately followed by the event in question (i.e. a recession), we will also define an average time lag between the signal and the occurence of the event.

As explained in a previous article, the yield curve can have three distinct shapes:

• Normal: Average or normal economic growth expected
• Steep: Above average economic growth expected
• Inverted: Negative economic growth expected
• Humped: Negative economic growth expected
• Flat: Transition period between normal and inverted yield curve

A more detailed explanation of each shape can be found here.

For the purpose of predicting recessions, we are focusing on the transition period from a normal to an inverted or humped yield curve.

To measure the shape of the yield curve with one variable, we can use the term spread, which is defined as the difference between the yield of a long-term bond and the yield of a short-term bond of the same curve. In the US, the most common term spread is the difference between 10-year and 2-year treasury bond (10y/2y spread).

For our analysis, we will first focus on the 10y/2y spread, which covers the back end of the curve. Later, we will also look at the 2y/FFR spread, namely the spread between the 2-year treasury bond and the current federal funds rate. This metric focuses on the front end of the curve. By considering both metrics, we make sure to not only focus on a specific part of the curve.

10-year minus 2-year spread

Figure 1 shows in blue the 10y/2y spread, and US recessions are highlighted by the shaded grey areas. The data ranges from 1976-06-01 to 2023-03-24.

During this time period, the US economy went through six recessions. We can see that all of the recessions were preceded by the 10y/2y spread crossing the horizontal axis from above. This is synonymous with an inversion of the yield curve between 2-year and 10-year maturities.

The table below summarizes the main findings from the chart:

Recession	First negative reading	Time lag	Recession length
Feb1980 – Jul 1980	Aug 1978	18 months	5 months
Aug 1981 – Nov 1982	Sep 1980	11 months	15 months
Aug 1990 – Mar 1991	Dec 1988	20 months	7 months
Apr 2001 – Nov 2001	Jun 1998	34 months	7 months
Jan 2008 – Jun 2009	Feb 2006	23 months	17 months
Mar 2020 – Apr 2020	Aug 2019	7 months	1 month

For the six past US recessions, the time lag between the first negative reading of the term spread and the occurence of the recession has ranged between 7 and 34 months, with a median value of 19 months.

The information provided in this article is for educational and informational purposes only and should not be construed as financial advice. The content of this article is intended to be a general overview and may not be appropriate for your specific financial situation. Before making any financial decisions, you should seek the advice of a qualified financial professional. The author is not responsible for any decisions or actions taken based on the information provided in this article.

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