US recessions since the mid 1950s have been preceded by a flat or inverted Treasury yield curve. Some commentators take comfort from current curve steepness but the rule-of-thumb has been rendered obsolete by near-zero short-term interest rates.

A summary measure of the slope of the Treasury curve is the gap between the yield on 10-year bonds and the discount rate on three-month bills. This has averaged 1.4% since 1955 but fell below 0.3% before the last nine recessions, turning negative in six cases – see chart.

The three-month Treasury bill rate, however, was at least 3% across these nine episodes versus only 0.2% today. It is necessary to examine earlier recessions to gauge a "warning level" for the gap when short rates are very low.

The four downturns between 1935 and 1955 each occurred against the backdrop of a positively-sloped curve. The closest parallel with today is 1937-38, when the three-month bill rate fluctuated in a 0.2-0.6% range. The curve flattened before the recession but the 10-year / three-month gap never fell below 2.3%.

This 2.3% minimum may be a reasonable guide to a recessionary level of the gap today. Assuming that the three-month bill rate remains at 0.2%, this implies that the 10-year yield, currently 3.0%, would have to fall to 2.5% or below to generate a warning signal.

Interestingly, the suggested critical level of 2.3% for the yield gap is close to the 2.5% used by John Hussman in his original list of recession-spotting criteria – see previous post. The newer version of his list, however, employs a higher value of 3.1%, contributing to his recent recession call (since the current reading is 2.8%).

As explained in the earlier post, 10 out of 11 post-war US recessions have been preceded by a contraction of real narrow money – currently still expanding. The central scenario here will remain a temporary slowdown rather than a "double dip" unless monetary trends deteriorate and / or the 10-year yield falls beneath 2.5%.