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Yield Curve Inversion - Necessary But Not Sufficient Recession Condition

As shown in the chart below, each of the past six recessions (shaded areas) was preceded by an inversion in the spread between the Treasury 10-year yield and the fed funds rate. But there were two other instances of inversion - 1966:Q2 through 1967:1 and 1998:Q3 through 1998:Q4 - immediately after which no recession occurred. It would appear, then, that an inverted yield curve is more of a necessary condition for a recession to occur, but not a sufficient condition. That is, if the spread goes from +25 basis points and to -25 basis points, a recession is not automatically triggered. Rather, whether an inversion results in a recession would seem to depend on the magnitude of the inversion and, to a lesser extent, the duration of it. Recession-signaling aside, the yield curve remains a reliable leading indicator of economic activity. Although the spread going from +25 basis points to -25 basis points might not result in a recession, it does indicate that monetary policy has become more restrictive. For a description of the theoretical underpinnings of why the yield spread is a leading indicator, see http://www.northerntrust.com/library/econ_research/weekly/us/pc070805.pdf. For some descriptive data on the past eight spread inversions, see the table below.

Table 1 - History of Spread Inversions
Period of Inversion* Average
Spread

(b.p.)
Maximum Negative
Spread

(b.p.)
Minimum Negative
Spread

(b.p.)
1966:Q2 - 1967:Q1 -30 56 13
1968:Q3 - 1970:Q2 -102 213 15
1973:Q2 - 1974:Q3 -295 413 101
1978:Q4 - 1980:Q2 -186 313 76
1980:Q4 - 1981:Q3 -326 361 273
1989:Q1 - 1989:Q4 -72 98 23
1998:Q3 - 1998:Q4 -26 33 19
2000:Q2 - 2001:Q1 -42 63 10
* Fed funds rate above 10-yr. Treasury yield

 

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