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Press Release

Reliability of the term spread as a predictor of recession probabilities may be affected by zero short-term interest rates, says Cleveland Fed economist

The difference between long- and short-maturity Treasury yields, known as the term spread, has produced intriguingly accurate predictions of economic activity and recessions in the US and abroad. But the fact that high-quality bond yields have been very close to zero in recent years may be hurting the predictive power of fixed-income spreads, according to O. Emre Ergungor, a senior economic advisor at the Federal Reserve Bank of Cleveland. Ergungor examines enhanced measures that include two additional variables: the credit spread and growth in corporate profits.

Ergungor explains that, when long-term yields approach negative territory, institutional investors such as insurance companies or pension funds that must earn positive nominal returns (due to their nominal liabilities) are likely to search for risky positive yields rather than accept negative yields in fixed-income bonds. Therefore, the yield curve may not invert when it should or as much as it should despite the anticipated path of the recovery.

Ergungor finds that a statistical model that includes the term spread and the credit spread (the difference between the yields of high- and low-quality bonds) has greater accuracy when predicting recessions 12 months ahead than a model that includes only the term spread. However, since the credit spread is subject to the same zero-lower-bound problem, Ergungor proposes another measure: the inflation-adjusted quarterly change in pre-tax corporate profits.

“Firms seem to adjust their production and investment after seeing a drop in their profits,” says the researcher.

Although the 12-month-ahead recession probabilities estimated using only the term spread have not exceeded 30 percent since the financial crisis, the estimates using credit spreads and growth in corporate profits tell a different story, says Ergungor. “The recession probability in the first quarter of this year may have risen to 73 percent excluding the quarterly change in profits or as high as 81 percent including them. These probabilities later declined to around 30 percent.”

Ergungor notes that these estimates must be interpreted cautiously. “The methodology is nothing more than a mechanism that puts investors’ anxiety and corporate profitability on a 0-1 scale. High measurements on this scale have often been followed by a recession in the past, but this is not a guaranteed outcome.”

Read Recession Probabilities

Federal Reserve Bank of Cleveland

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.

The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.

Media contact

Doug Campbell,, 513.455.4479