The Effectiveness of Term Spread as a Predictor of Recessions

This paper is relevant for evaluating the probability of an impending recession following multiple yield curve inversions in 2022. Evidence of an oncoming recession is of great interest, as policymakers may respond by adjusting monetary and fiscal policy while market participants may utilize it to assess investment risks. Forecasts of impending recession also interest households and businesses for financial planning in the near term. My results show that the yield curve spread for the sample period from 1972 to 2022 exhibits strong predictive power for recessions that occurred during the 1970s and early 1980s. However, the yield curve spread of the post-1997 sample has much less predictive power. The real yield including the TIPs yield and inflation-adjusted yield does not seem to have stronger predictive power than nominal yields, which needs further analysis due to the limit of sample size and measurement error. Overall, the yield curve spread is still an effective predictor of recessions. Particularly, adding the term spread in addition to recession indicator variables yields a better in-sample fit.