The interest rate spread is a powerful tool for forecasting periods of economic growth and recession. A positive interest rate spread forecasts economic growth in the next year, while a negative interest rate spread forecasts a recession in the next year.

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The interest rate spread reveals the prevailing opinion among investors regarding future economic conditions. During a recession, when output is declining, interest rates also tend to decline because the demand for borrowed funds is low. If investors anticipate a future recession and declining short-term interest rates, they will sell off their short-term bonds and buy longer-term bonds, which can cause the interest rate spread to invert, or become negative. The interest rate spread successfully forecasted the last two recessions.

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The logic of using the interest rate spread to forecast recessions is not limited to the U.S., but in fact applies to most any market economy. For example, the following article by Frank Smets and Kostas Tsatsaronis of the Bank of International Settlements relates the forecasting capacity of the interest rate spread in the U.S. and Germany.

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