Safehaven | Yield Curve Inversion - Necessary But Not Sufficient Recession Condition

December 21, 2005

Yield Curve Inversion - Necessary But Not Sufficient Recession Condition
by Paul Kasriel

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

Paul L. Kasriel, Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.