Using Term Spreads to Forecast the End of Economic Expansions in the U.S.

Abstract This paper uses a binary dependent variable model to determine whether the U.S. economy is in the final year of an economic expansion, the alarm period before a recession arrives. The slope of the yield curve is the sensor used to forecast a subsequent economic downturn. Different from the previous literature, we look at a variety of spreads and inflationary expectations differentials. The final probit specification to forecast the end of economic expansions contains different spreads instead of the typically used single 10-Year Government Bond minus the 3-Month Treasury Bill or the 2–10 spread, plus an explicit measure of inflationary expectations. The resulting specification is more general than the more restrictive forecast using a single spread, a formulation that is rejected by the data both for the sample period reaching back to 1954 and separately to 1976.