Can shifts in the Treasury yield spread predict economic downturns? A common belief is that widening spreads indicate stable economic conditions for the near future—as reflected by market expectations about future interest rates and inflation. On the other hand, narrowing spreads (including negative spreads) may signal worsening conditions. Data in FRED can shed some light on how well this concept has held up in the past two decades.
The graph above shows that yield spreads between the 10- and 2-year notes fell to a low of -0.41 percentage points in April 2000: This was in line with the worsening economic conditions and the recession from March to November 2001. In November 2006, yield spreads between these notes dropped down again to a valley of -0.15 percentage points. And, again, this development was followed by the 2007-2008 global financial crisis. So, it seems the theory that recessions follow negative yield spreads does happen to match the economic data. Despite this recent pattern in U.S. Treasury bill spreads, though, we cannot confidently assert that negative spreads predict recessions. To classify spreads as strong indicators, we’d need much larger datasets—including longer periods and other economies. So, the examination of bond yield spreads continues…
How this graph was created: Search for “10-Year Treasury Constant Maturity Minus 2-Year”; select “line” as the format and “monthly” as the frequency. Set the starting date as “1997-05-01” and the ending date as “2017-05-01.”
Suggested by Wei (Wilson) Wang.