There is one model which takes into account the spread between the 10 Year Treasury Bond Yield, the 3 Month Treasury Bond Yield and the Federal Funds Rate. This model was created by Federal Reserve Board's Jonathan Wright in The Yield Curve and Predicting Recessions.
Some general points regarding the Yield spread and the Fed Funds Rate:
- The bigger the difference between the 10 Year Treasury Bond Yield minus the 3 month Treasury Bond Yield, the less likely a recession will occur within the next twelve months. This the the normal upward sloping yield curve. The bigger the difference between the 3 Month Treasury Bond Yield minus the 10 Year Treasury Bond Yield, the greater the chance of a recession within the next 12 months. This is the inverted yield curve case.
- The higher the Fed Funds Rate, the greater the odds of a recession within the next twelve months.
To Calculate, use the calculator on this website. The calculation is based on Jonathan Wright's work mentioned above.
You will need these:
- The 10 Year Treasury Bond Yield. Get the information from Stockcharts.com using $UST10Y. The value of the $UST10Y, is the Yield on the treasury. Currently, as of August 31, 2007, the 10 Year Yield is 4.54%
- The 3 Month Treasury Bond Yield. Get the information from Stockcharts.com using $UST3M. Currently, the 3 Month Treasury Bond Yield is 4.01%.
- The Fed Funds Rate. Go to Bankrate.com to get the current Fed Funds Rate. It is currently at 5.25%. You can also estimate the odds of a Fed Rate Cut Here.
Chance of Recession as of August 31, 2007: 23%
Now to do the actual calculation, go to the website with the calculator.
Using the values mentioned above, we find out that there is a 23% chance of recession within the next twelve months. If the Fed cuts rates by 0.50%, then the odds of a recession (let's assume that the yield spread remains the same) goes down to 18%.