US Recession Risk Assessment - Interest Rates

Talk has recently turned to recession in the US.  One indicator used is the differential between 10 year and 2 year government bonds, under the assumption that two year bonds are more sensitive to the business cycle and act as a leading indicator.

So, how do things look?

On the graph below, we can see the 2006 to 2012 period.  In mid-2007, two year rates (green) started to plummet.  By contrast, ten year rates (blue) declined, but more modestly.  By this metric, the 2-10 interest rate differential (gray) gave about six months' notice of a pending recession.

US Ten Year (blue), Two Year (Green) Bond interest rates, and 10-2 Year Differential (gray) Source: US Treasury

US Ten Year (blue), Two Year (Green) Bond interest rates, and 10-2 Year Differential (gray)

Source: US Treasury

How do we look now? 

After 2012, the differential stabilized, but jumped back up to 3% in late 2013 (but no recession), and has since declined in almost secular trend.  At 1.2%, the differential is at it lowest level since early 2008.  In other words, as of the 15th, the differential spoke to the continued consolidation of the economy.  Now, it is true that the short rate has declined by 30 basis points in the last few weeks, but so has the long rate.  Thus, the decline for the moment looks more like overall credit conditions (fear and loathing at the PBoC, in my opinion), rather than specific US cyclical economic factors.