Term spread data and the probability of recession one year ahead
The difference between long- and short-term interest rates, the term spread, may be used to calculate a probability that the economy will be in recession one year ahead. This probability is based on expectations of future economic activity that are incorporated in bond prices. The charts below illustrate how one particular term spread is converted into a probablity with accurate leading indicator properties.
Term Spread Chart
The difference between 10-year and 3-month Treasury rates, which is normally positive, has turned negative before each of the last seven officially-dated U.S. recessions. The only "false signal" came in 1966-67, shortly before an episode that was labeled a credit crunch by many, a mini-recession by some, and a recession by Nobel laureate Milton Friedman.
Probability of
U.S. Recession Chart
This model converts the difference between 10-year and 3-month Treasury
rates into a probability of a recession in the United States
twelve months ahead. Estimated using recession indicator data from January 1960
to December 2010. See references, especially, Estrella and
Hardouvelis (1991) and Estrella and Trubin (2006).
Monthly data (xls file)