- Studies have shown that since the 1970s, an inverted yield curve—which occurs when short-term interest rates rise above long-term rates—has been a reliable signal of a recession twelve months later.
- One view holds that the ability of the yield curve to predict recessions stems from interest rate expectations: market participants anticipate an easing of monetary policy in response to an upcoming deterioration in the economic outlook, and the decline in expected future short-term rates drives down current long-term rates.
- In addition to this “expectations” component, theory suggests that interest rates also reflect a “term premium” component. Investors require higher long-term rates to compensate for the greater risk of holding long-term rather than short-term securities.
- Standard term spread models used to forecast recessions typically combine the effects of these two distinct components.
- Some have argued that the yield curve inversion in August 2006 did not signal a recession because it was driven by an unusually low level of the term premium rather than by changes in interest rate expectations.
- Rosenberg and Maurer demonstrate how the expectations and term premium components of the yield curve affect recession predictions by constructing a forecasting model that excludes the term premium. They compare their model’s performance predicting past recessions with that of the standard term spread model.
- The authors find some evidence that the model using only the expectations component predicts recessions more accurately than the standard term spread model does.
- Although Rosenberg and Maurer caution that the historical data they use are insufficient to produce a definitive conclusion, their findings do support the view that interest rate expectations are the source of the yield curve’s predictive power.
- Significantly, a model using only the term premium component performs poorly in predicting recessions.
- The study also finds that while signals from the standard term spread model indicated an imminent recession from August 2006 to May 2007, the model with only the expectations component did not signal a recession. The authors observe that to date, it is unclear which model’s prediction was correct.