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

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by: Econbrowser

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).