Yield Curve Model: Zero Probability of New Recession

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Returning to the continuing debate about a ‘Double Dip’ recession, I thought we would look at one of the most basic models of the business cycle: the yield curve.

Put simply, the yield curve theory says that if long term rates are lower than short term rates, then the central bank is forcing the economy to slow down. And if short term rates are lower than long term rates, as we they are now, then the central bank is reliquifying the economy and priming future growth. So within the yield curve we have a simple but effective economic indicator.

We’ve already looked at several models which attempt to predict the economic future. Among these are the ECRI’s WLI, MacroAdvisor’s recession probability model, and finally the “Anxious Index”. Of these, all are in agreement that there will be no new recession.

Another model is based on the yield curve and it too agrees with the others that the probability of a new recession is extremely low. Considering the extremely steep slope of the yield curve, this isn’t surprising. To be more precise, the model puts the probability of a new recession at just 0.06%:

Source: New York Fed (with thanks to Mark Hulbert)

This is based on research by Arturo Estrella and Frederic S. Mishkin (see report below) which looks at the relationship between the yield curve and the occurrence of recessions.

The other time in recent history that we had a double dip recession was early 1980’s. NBER dates recessions in hindsight of course, whereas this is a prediction model that attempts to find them ahead of time. In August 1981, at which point NBER would denote to be the start of a second recession (Double Dip) much later in time, the yield curve model was predicting that the chance of a recession to be 3.6%. In September, one month after the recession had already started, it jumped to 11.3% and two months later, in October 1981, it jumped again to 37.6%. By November 1981 there was little doubt with a 75% probability.

In a recent interview, James Stack of InvesTech, reminds us that all this talk of a ‘Double Dip’ is common during the first stage of an economic recovery. Stack is a market technician whom I respect, and for what it’s worth, he’s continuing to be fully invested with a 95% allocation to equities.

Of course, all of this is no guarantee of any sort. As it was in the early 1980’s, we could see more than just a deceleration and an outright recession (again). But at the moment, everything I’m looking at, including the ECRI’s often cited WLI is not giving us enough reasons to assume that.

The disconcerting thing is, as James Mackintosh points out in this video from FT’s Short View, today the Federal Reserve has basically no room to cut rates further. The only other option, faced with a recession, is “QE II: the Re-reliquefaction”. Otherwise known as Helicopter Ben’s Last Stand.

Here is the explanation of the predictive model mentioned above:

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“Frederic S. Mishkin” Ha! Ha! LOL

The first sentence of the second paragraph should state that long term rates are “lower” not higher that short term rates.

Mark, you laughing at his 2006 Icelandic report?

fouad, thanks - corrected now.

yield curve theory holds true as long as the economy is in a normal condition, however, 1. credit markets are still uptight with lending to small business, self employed must save or not spend (lack of credit = lack of growth = lack of spending) , 2. In a deflationary time, which is mostly wage deflation, there is less money circulating in the economy by the individuals employed in the public sector. Now, add up to it 10% unemployment, global slowdown = (hiking productivity = increasing layoffs) = [yes, we might have good earnings but this cash stays in the corporate world]. Where exactly spending is coming from?

What was the experience with this measure in Japan?

Hi Babak, I would oppose this view on economic recessions based on the yield curve for a very simple reason: the time frame chosen (1970 to 2010) was a period of intense inflation of the credit supply, so the fed was indeed able to “slow down” or “liquify” the “economy”. Today, with the deflationary environment, they won’t be able to do anything but push on a string. We are already in the second dip, if you believe we ever got out of it!

ECRI Weekly Leading Indicators at Negative 9.8; Has the ECRI Blown Yet Another Recession Call?


There is a major problem with the yield curve argument - it leaves out the mechanism by which it works: credit growth.

The yield curve normally works as a predictor of recessions because, when the curve is steep, bank lending resumes and demand for credit rises, prompting the economy to recover. When the yield curve inverts, short term rates rise, raising the price of credit and discouraging growth.

However this time, even with the steep curve, bank lending has not risen but fallen and demand for credit remains weak. Neither demand nor supply are able to stimulate the economy. The yield curve argument is therefore not applicable in this case - just as it wasn’t in 1937 when the economy failed yet the curve was positive.

Here’s the argument in more detail

OnTheMoney basically phrased what I meant, but in a far better way

i doubt that yield curve theory works with ZIRP. would love to see this study on japan since they went to zero.

“Hotairmail” has it exactly right. Having ZIRP like Japan will ensure that you never get an inverted yield curve. And did that prevent recessions in Japan?

So come on please, enough with the yield curve nonsense!! What a misleading proposition.

“GreenAB” and “Rod”, the issue is not so much ZIRP as credit saturation: No one needs nor wants to borrow, even at Zero% That’s what “Hotairmail” meant, as well as “OnTheMoney” and myself.

I agree with the above views, in an environment with very low (almost zero) official rates, the curve can not go negative or even come close to it. As for the Japanese experience, their curve has not been negative, or even come close to negative since 1991.

I wrote a posting about this a few weeks ago (which shows the Japanese yield curve since the early 1990s) . I have attached the link

OnTheMoney is correct imho. Big implications of this b/c most recession indicators incorp the yield curve so may not be as applicable as the past. Not ECRI notably.

Establishment exploration of this view can be seen in Paul Kasriel’s latest note at Northern Trust. See the last page, final chart. Nutshell, the credit transmission mechanism is broken (usefulness of yield curve indicator) and this time may be different.


Consumer spending, even with the high unemployment, has exceeded the old highs. Perhaps you are unaware of this.

The yield curve is distorted in today’s environment because we have hit the zero bound. It can’t go negative by definition when the short-term rate is zero, so the usual rules don’t apply.

Mind you, I suspect that we aren’t going to double dip, either. But I wouldn’t use a conventional approach to the yield curve to prove it.

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