Economics & Growth | Monetary Policy & Inflation | Rates | US
US Yield Curve Gives 40% Probability of Recession
- By Dalvir Mandara and Bilal Hafeez
- 2 min read
The yield curve is one of the most reliable predictors of recession. When long-term yields start to fall towards or below short-term yields, the curve flattens or inverts. This has often predicted a recession in subsequent months. The last time the US curve (2s10s) inverted was August 2019. Within six months, the global economy was in recession. Admittedly, the COVID pandemic was a big factor, but the US economy was already slowing.
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The yield curve is one of the most reliable predictors of recession. When long-term yields start to fall towards or below short-term yields, the curve flattens or inverts. This has often predicted a recession in subsequent months. The last time the US curve (2s10s) inverted was August 2019. Within six months, the global economy was in recession. Admittedly, the COVID pandemic was a big factor, but the US economy was already slowing.
The Fed has even built a model on the US yield curve that gives a recession probability. They prefer to compare 10-year yields to the very front end of the curve, three-month cash rates, so the 3m10y curve. With Fed policy rates still at zero, the curve is still steep. As a result, their model is currently giving a 3% probability of a recession (Chart 1).
However, we prefer to look at two-year yields rather than three-month yields. The two-year would better capture expectations for Fed hikes in coming years. It is therefore more forward-looking. So, our preferred yield curve is the 2y10y curve (10-year yields minus two-year yields). If we use this in our recession model, we currently get a recession probability of 40% (Chart 2). This is a significant increase from the start of the year when it was 18%. So far, the Russia-Ukraine situation has not changed the probability much, but we will be monitoring it closely.
Other than using two-year yields, what other indicators could we be looking for to signal a recession? Im thinking things in terms of GDP, NFP etc, do any of these matter? or do they just matter less?