Recessions and flattening of the yield curve (1960-2021): a two-way road under a regime switching approach

ABSTRACT

The one-way relationship that goes from the term spread to recessions has been widely studied. However, the relationship between term spread and the business cycle, in addition to being bidirectional, is conditioned by the cyclical phase itself. To demonstrate this, we have modelled the bidirectional relationship between term spread and the business cycle by extracting two interrelated latent Markov variables the first, drawn from four activity indicators, replicates the phases of the US business cycle;the second, from the term spread of the yield curve, identifies two regimes an ordinary regime (positive slope) and a flattening regime. By analyzing both the transition between these regimes and forecasted probabilities, we find that this bidirectional relationship is not symmetrical. That is, the term spread signals a change in the business cycle regime while the cyclical factor only signals the beginning of the ordinary regime of the term spread, not its ending. To illustrate the model, we confirm the beginning of the COVID-19 recession in March of 2020, and the corresponding start of the ordinary regime in the term spread.