The 3-month and 1-year Treasury yields have gone way up in the past year, but the overall spread (say between them and the 10-year) is still quite positive, so the classic warning of an impending recession is still not here. Here’s a long-term chart:
In the chart above, the red line is the 10-year yield, the green line is the 3-month yield, and the blue line is the difference between them.
So, if you just look at the blue line and the recession bars, you can see that the blue line always goes negative before a recession.
But by decomposing it, you can see that specifically what happens is that short rates zoom upward to exceed long rates. (In principle the yield curve could invert if long rates collapsed below short rates. But this chart shows, that’s not how it actually happens historically.)
In this paper, I argue that the Austrian business cycle theory, among its other virtues, can explain the predictive power of the yield curve. Specifically, central banks have more control over short rates than long rates. So in standard Austrian theory we say the central bank “raises rates” and this causes the boom to turn to a bust. Well, when you get more specific about it, that would mean short rates go up while long rates (which are a combination of expected real growth and price inflation) will stay put or possibly even go down.
So, if you buy the basic story of ABCT, then out pops the fact that an inverted yield curve “predicts” recessions as a bonus.
** For a full explanation of the Austrian theory of the business cycle, see my new book Choice from the Independent Institute.