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

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  • Cendejas Bueno, José Luis

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.

Suggested Citation

  • Cendejas Bueno, José Luis, 2023. "Recessions and flattening of the yield curve (1960–2021): A two-way road under a regime switching approach," The Quarterly Review of Economics and Finance, Elsevier, vol. 88(C), pages 8-20.
    • Handle: RePEc:eee:quaeco:v:88:y:2023:i:c:p:8-20
    DOI: 10.1016/j.qref.2022.12.007
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    More about this item

    Keywords

    Term spread; Inverted yield curve; Markov switching model; U. S. business cycle; COVID-19 recession;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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