Is yield curve predicting a US recession in 2020?

• DOI: http://doi.org/10.1002/jcaf.22400
• Published date: 01 July 2019
• Date: 01 July 2019
• Author: Damir Tokic

EDITORIAL REVIEW

Is yield curve predicting a US recession in 2020?

Damir Tokic

International University of Monaco/INSEEC

Paris

Correspondence

Email: dtokic@inseec.com

Abstract

The yield curve spread has predicted every US recession. As of mid-2019, the

inverted yield curve spread is flashing a warning sign about a possible US reces-

sion in 2020. This article explains the yield curve spread, and discusses the possi-

ble 2020 recession triggers.

1|YIELD CURVE SPREAD AS A

LEADING RECESSION INDICATOR

The yield curve spread has predicted every US recession since

1950. Specifically, the difference between the yield on

10-Year Treasury (T) Bond and 3-Month T-Bill turns negative

before each recession, which has been confirmed by numerous

academic literature (e.g., Estrella & Hardouvelis, 1991;

Estrella & Mishkin, 1996; Ahrens, 2002; Chauvet & Potter,

2005; Estrella & Trubin, 2006). In fact, the yield curve spread

outperforms all other indicators in predicting recessions.

The expectations hypothesis of the yield curve spread

intuitively explains the predictive power of the yield curve.

Specifically, it proposes that a long-term interest rate is

essentially the average of expected future short-term interest

rates. So, the yield on 10-Year T-Bond is equivalent to the

average of ten 1-Year forward rates. Thus, the expectations

hypothesis of the yield curve incorporates the actual mone-

tary policy and the expected future monetary policy into the

predictive model.

For example, the yield curve spread flattens (or inverts)

when the Fed increases short-term interest rates, and the mar-

ket participants predict that this policy action would cause an

economic contraction in the near futures. Consequently, mar-

ket expects that the Fed would be forced to reverse the policy

action in the future and lower the short-term interest rate.

Thus, the expected decline in the future short-term interest

rate lowers the actual long-term interest rate, which first flat-

tens and eventually inverts the yield curve.

During the last three US recessions, the 10 year-3 month

yield curve spread first inverted about 9–18 months before

the actual recessions started, as illustrated in Figure 1. Most

recently, the 10 year-3 month yield curve spread first

inverted on March 22, 2019, and again on May 13, 2019.

Thus, the question is whether this specific yield curve inver-

sion signals a US recession in 2020?

2|IS THIS TIME DIFFERENT?

Consistent with the historical experience, many observers

point to the yield curve spread as a consistently effective

predictor of recessions. Yet, some always question its effec-

tiveness and argue that “this time is different.”For example,

the Fed Chairman Greenspan rejected the expectations

hypothesis predictions of the inverted yield curve spread

before the 2008 recession, and argued that it was the global

savings glut and the resulting global demand for the longer

term bonds that caused the flattening and inversion of the

yield curve (Tokic, 2009). In retrospect, the expectations

hypothesis correctly predicted the 2008 recession and the

Fed's monetary policy action during and after the financial

crisis of 2008. Similarly, many observers question whether

the inverted yield curve spread in 2019 is predicting a reces-

sion in 2020, or whether this time really is different.

It is true, however, that each recessionary episode has been

somewhat different. For example, the recessions in late 1970s

and early 1980s were deliberately caused by the Fed aiming to

control the rising inflation—these were inflationary recessions.

The Fed was forced to invert the yield curve to stop the run-

away inflation, at the cost of causing a recession. The reces-

sion of 2000 coincided with the burst of the dot.com bubble.

The recession of 2008 was caused by the bursting of the hous-

ing bubble, and the resulting credit crunch. In both of these

Received: 24 May 2019 Accepted: 24 May 2019

DOI: 10.1002/jcaf.22400

J Corp Acct Fin. 2019;30:5–7. wileyonlinelibrary.com/journal/jcaf © 2019 Wiley Periodicals, Inc. 5