Plain Vanilla Term Spread Forecasts of Recession

What do simple 10yr-3mo and 10yr-2yr Treasury spreads imply about recession probabilities?

Figure 1: 12 month ahead estimated probability of recession using 10yr-3mo Treasury spread (blue), and using 10yr-2yr spread (red). NBER defined recession dates peak-to-trough shaded gray. Source: Treasury via FRED, NBER and author’s calculations.

Reflecting the drastically diverging trajectories of the spreads, the probability estimates also diverge. A common alternative specification includes the inflation adjusted level of the fed funds rate. In the detail below, I show the two forecasts above and this alternative.

Figure 1: 12 month ahead estimated probability of recession using 10yr-3mo Treasury spread (blue), 10yr-3mo spread and fed funds minus ex post lagged inflation (light blue), and using 10yr-2yr spread (red). NBER defined recession dates peak-to-trough shaded gray. Source: Treasury via FRED, NBER and author’s calculations.

This alternative does not produce a substantially different forecast.

Hence, if past correlations hold into the future, then a recession in the next 12 months is not likely. However, it must be admitted that there are many different spreads that one can consider (see e.g. here).