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So, the fact that the two year and the ten year inverted this week does not mean we will see a recession next year. In fact, it may not mean anything other than it was a slow week in the bond pits. We saw the spread on the yield curve roughly where it is today in 1996. It was four years later that we had a recession. Hear is a graph of the 90 day-ten year yield curve spread.

Yet, as we will see below, the inversion is not without interest to investors. So what can meaning can we draw?

Estimated Recession Probabilities
Estrella and Mishkin developed a probability table about how likely a recession would be 4 quarters later given a particular level of the yield curve spread. Let's look at that table from the 1996 paper.

The spread in the table above is the 90 day average. Basically, if the spread is 0.46 basis points, there is a 15% probability of a recession four quarters later. And that is roughly where we are today. The 90 day average is 0.52%.

But that level of spread has happened several times in the past 40 years and we have not had a recession follow. So why should we pay attention today?

Because for a full inverted yield curve to show up you will start seeing "signs" in the yield curve like we saw this week. These things start innocuously, usually when the economy seems to be booming, and most observers suggest we ignore them. And sometimes they are right.

But most observers suggested we ignore full-blown yield curve inversions as well. I think it was something like 50 out of 50 Blue Chip economists failed to predict the last recession even a few months out. They ignored the yield curve, all finding reasons why "this time it's different."

In a follow-on paper mentioned below, Estrella documents that each of the previous yield curve recessions since 1978 produced major academic papers telling us why this time it's different. They were all wrong. If we have another yield curve inversion, we will have another spate of papers and economists suggesting that we ignore the curve as well. That is one prediction you can take to the bank.