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

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 condi-tioned 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 flat-tening 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.(c) 2022 The Author. Published by Elsevier Inc. on behalf of Board of Trustees of the University of Illinois. This is an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/ 4.0/).