United States: Yield Curve and Periods of Economic Recession

The yield spread, i.e. the difference between long term and short term interest rates, has been a good indicator historically of possible future recession. A flattening and then inversion of the spread has correctly predicted the seven US recessions since the 1960s. The question you may have is "why".

Central Banks use monetary policy to influence economic activity. When central banks face tradeoffs between rising inflation and slowing economic growth and chose the latter, the banks push up the short term interest rates. As a result, spending declines in the interest-rate sensitive components of the economy, such as business capital spending, residential development, and consumer durables (especially automobiles). This in turn slows economic activity. 

The challenge is how far to adjust interest rates to get the desired effect on economic activity and keep inflation within the target range. A miscalculation risks recession on the one hand and markets factoring a future correction (in the form of short term rate reduction) and lower inflation in the long term interest rate outlook. These two factors together push the long term interest rate lower than the short term interest rate. And, that is how the yield curve spread gains its predictive potential.

Evolving economic dynamics around the globe could potentially weaken the predictive power of the spread. Central banks have been buying long term bonds since the 2008-09 financial crisis to artificially depress the long term interest rate. This is a new trend for banks. These actions have also contributed to lower long term bond yields. When we look, however, to the spread between the 10 year and 2 year US Treasury yields, no inversion has materialized yet,  suggesting that if despite these new trends we still consider the spread as a good predictive indicator, recession may still be sometime off.