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The Fed funds rate is at 5%. It is highly likely it will go to 5.5% at the end of September. If the ten year does not move upward, you could see the beginning of a full yield curve inversion. That will put us on "official" yield curve watch. Since that seems like a real possibility, let's look at some of the specific points in the 1996 paper.

In 1989, the yield spread predicted a 25% probability of a recession showing up in 1990 and one did. It was mild, but that was small comfort to those who got caught in its trap.
Further, the Fed paper authors tell us that things have changed and that now we should be much more concerned about a "mere" 25% probability. Quoting:

"Thus, even a probability of recession of 25 percent--the figure forecast for the fourth quarter of 1990 data on the yield curve spread one year earlier--was a relatively strong signal in the fourth quarter of 1989 that a recession might come one year in the future."

Further down they say,

"There are two reasons why the signal for this [1990] recession may have been weaker than for earlier recessions. First, restrictive monetary policy probably induced the 1973-75, 1980 and 1981-82 recessions, but it played a much smaller role in the 1990-91 recession. Because the tightening of monetary policy also affects the yield curve, we would expect the signal to be more pronounced at such times. Second, the amount of variation in the yield curve spread has changed over time and was much less in the 1990s than in the early 1980s, making a strong signal for the 1990-91 recession difficult to obtain."

Basically they are saying that future studies a few decades from now will probably have much higher probabilities of recession at lower spreads than did their study because things, like volatility, have changed.

The 90 day yield curve in 1990 only went to a negative (-) 0.13%. It got to -0.71% at the end of 2000, with the worst one day number being January 2 of 2001 when it was -0.95%. Interestingly, from that point the spread went positive in less than a month. (For what it's worth, the weeks around Christmas and New Years saw really odd and wild volatility.)

The 10 Year - 30 Year Connection
The Treasury plans to start issuing new 30 year bonds in February. This will be of interest as there is an interesting relationship I have noted back in 2000 between the ten year and the 30 year bond.

 Just for kicks, I went to the Federal Reserve web site (http://www.federalreserve.gov/Releases/H15/data.htm) and downloaded the interest rates on 10 year and 30 year bonds since 1977. Then I did a comparison. Curiously, it is not at all uncommon for the 10 year rate to go above the 30 year rate.

In fact, it seems to happen about 18 months or so before a recession or a stock market crash. Not just one time but every time the 10 year/30 year rates became inverted since 1980 we had either a recession (in 1980, 1982 and 1990) or the '87 stock market crash. 
I should point out that in 1987 we did not see an overall negative yield curve while we did prior to the recession years.

For the record, Bloomberg says the 30 year is at 4.54%. Since there are no actual 30 year bonds (the longest note would be about 25 years), I assume they have some method for giving us this number. No matter, in a few months we will have a real number. And we can then compare it to the ten year.

If for some reason that 30 year drops below the ten, you can bet many economists will argue that it is a result of the Fed not offering enough 30 year bonds so that demand drove the rates down. I should point out they made very similar arguments in 2000. Of course, when things went back to normal in late 2000, those arguments began to ring hollow. They will this next time as well.

Some Conclusions
Arturo Estrella is now the Senior Vice President, Capital Markets Function Federal Reserve Bank of New York. In October of last year, he produced a very useful primer on the yield curve at http://www.newyorkfed.org/research/capital_markets/ycfaq.html. For those of you who want more on the academic research on yield curves, I highly recommend it.

He concludes it with the following question and answer. It is instructive for us to look at what he says (emphasis mine):

Q. Should we expect the predictive power of the term spread for real activity to persist?

 A. Accumulated experience with the forecasting power of the yield curve suggests that it is much more than a passing phenomenon. Warnings of its actual or possible demise are often voiced, as in Butler (1978), Furlong (1989), Watson (1991) and - to some extent - Dotsey (1998), 

but the fact remains that recessions still seem to follow inversions quite inevitably, as recently as in 2000-2001.

Like many empirical models, some formal predictive models that forecast output growth based on the term spread seem to have a structural break around 1979-1980. Stock and Watson (2003) find substantial evidence of a break for models that predict output growth and Estrella, Rodrigues and Schich (2003) find more modest evidence for models that predict industrial production.