Is yield curve predicting a US recession in 2020?

Published date01 July 2019
Date01 July 2019
Is yield curve predicting a US recession in 2020?
Damir Tokic
International University of Monaco/INSEEC
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.
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 918 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?
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 inflationthese 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 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;30:57. © 2019 Wiley Periodicals, Inc. 5

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