Post War, How Many Times Has The 10yr-3mo Spread Fallen Below 1% Without A Recession Following?

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Editor's note: This article was originally published on December 7, 2017, by Menzie Chinn here.

Three times.

Figure 1: Ten-year minus three-month Treasury spread (blue), and ten-year minus three-month Treasury spread (blue). December observations pertain to 12/6 daily observation. NBER defined recession dates shaded gray. Source: Federal Reserve via FRED, NBER and author's calculations.

In general, once the yield spread is shrinking, it continues to shrink (so the question posed pertains to observations of the 1% threshold being breached as the spread goes down). You can see these instances where the yield curve breaches 1% from the topside in the following graph (red arrows).

Figure 2: Ten-year minus three-month Treasury spread (blue); December observation (blue x) pertains to 12/6 daily observation. NBER defined recession dates shaded gray. Red arrow denotes observation where spread cuts 1% threshold from above and then rises again and/or no recession follows. Source: Federal Reserve via FRED, NBER and author's calculations.

So... inversion (which is increasingly considered plausible) is not necessary to say a recession is likely impending.

This is an informal approach; a formal, statistical approach involves running a probit regression 1967M01-2017M11:

recessiont+6 = -0.332 -0.575×(GS10-TB3MS)t + ut

Both coefficients are statistically significant (the McFadden R2 = 0.22); the implied probability of recession is 16% for May 2018.

This is slightly higher than the estimates I obtained using this specification back in September. Of course, this formal forecast assumes that the behavior of the term premium is unchanged over time, a presumption that is questionable.

For more formal, cross-country, analyses, see Chinn and Kucko (2015).

This article was written by

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James D. Hamilton has been a professor in the Economics Department at the University of California at San Diego since 1992. He served as department chair from 1999-2002, and has also taught at Harvard University and the University of Virginia. He received a Ph.D. in economics from the University of California at Berkeley in 1983. Professor Hamilton has published articles on a wide range of topics including econometrics, business cycles, monetary policy, and energy markets. His graduate textbook on time series analysis has over 14,000 scholarly citations and has been translated into Chinese, Japanese, and Italian. Academic honors include election as a Fellow of the Econometric Society and Research Associate with the National Bureau of Economic Research. He has been a visiting scholar at the Federal Reserve Board in Washington, DC, as well as the Federal Reserve Banks of Atlanta, Boston, New York, Richmond, and San Francisco. He has also been a consultant for the National Academy of Sciences, Commodity Futures Trading Commission and the European Central Bank and has testified before the United States Congress. _________________________________________________ Menzie D. Chinn is Professor of Public Affairs and Economics at the University of Wisconsin’s Robert M. La Follette School of Public Affairs. His research is focused on international finance and macroeconomics. He is currently a co-editor of the Journal of International Money and Finance, and an associate editor of the Journal of Money, Credit and Banking, and was formerly an associate editor at the Journal of International Economics and the Review of International Economics. In 2000-2001, Professor Chinn served as Senior Staff Economist for International Finance on the President’s Council of Economic Advisers. He is currently a Research Fellow in the International Finance and Macroeconomics Program of the National Bureau of Economic Research, and has been a visiting scholar at the International Monetary Fund, the Congressional Budget Office, the Federal Reserve Board and the European Central Bank. He currently serves on the CBO Panel of Economic Advisers. With Jeffry Frieden, he is coauthor of Lost Decades: The Making of America’s Debt Crisis and the Long Recovery (2011, W.W. Norton). He is also a contributor to Econbrowser, a weblog on macroeconomic issues. Prior to his appointment at the University of Wisconsin–Madison in 2003, Professor Chinn taught at the University of California, Santa Cruz. He received his doctorate in Economics from the University of California, Berkeley, and his AB from Harvard University.

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