The difference between long- and short-term interest rates, the term spread, may be used to calculate a probability that the economy will be in recession one year ahead. This probability is based on expectations of future economic activity that are incorporated in bond prices. The charts below illustrate how one particular term spread is converted into a probablity with accurate leading indicator properties.
Term Spread Chart
The difference between 10-year and 3-month Treasury rates, which is normally positive, has turned negative before each of the last seven officially-dated U.S. recessions. The only "false signal" came in 1966-67, shortly before an episode that was labeled a credit crunch by many, a mini-recession by some, and a recession by Nobel laureate Milton Friedman.
This model converts the difference between 10-year and 3-month Treasury rates into a probability of a recession in the United States twelve months ahead. Estimated using recession indicator data from January 1960 to twelve months prior to the end of the data sample. See references, especially, Estrella and Hardouvelis (1991) and Estrella and Trubin (2006).