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The yield spread, the difference between long term and short term interest rates, has been a good indicator of a possible future recession. The spread has correctly predicted the last seven recessions since 1960s. Why would we consider the spread as a good indicator for recession apart from the historical correlation? The central bank, through its monetary policy, has significant role in economic activity. When central bank faces tradeoff between high inflation and slow economic growth and choses later over former, it pushes up short term interest rate. As a result, spending declines in the interest sensitive parts of the economy like business capital spending, residential development and consumer durables especially automobiles. This slows down the economic activity. However, it’s not an easy for the central bank to estimate an appropriate level of interest rate that will slow down the economic activity to a desired level to bring inflation to a target level. A little extra tightening in the monetary policy results into economic activity slowing down more than desired and thus pushing the economy into a recession. On the other hand, like any financial market bond market is forward looking, and therefore, it senses that the future short term rate could be lower as more than desired slowdown or recession would push the central bank to start easing the interest rate. It also starts factoring in lower inflation in its long term interest rate outlook. These two factors together pushes the long term interest rate lower than the short term interest rate. Therefore it makes sense that the yield curve spread has potential to predict recession. However, evolving economic dynamics around the globe could potentially makes the predictive power of the spread weak. The central banks around the world have been buying long term bonds after 2008-09 financial crisis to artificially keep the long term interest rate down which was not the case before. That has also contributed to the lower long term bond yields. Moreover, the spread between the 10yr and 2yr US Treasury yields has not yet inverted which suggests that even if we consider it is a good indicator, recession may still be away.

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