As many of the long time readers of this site know, I have been tracking the yield curve for quite some time.  I began tracking it in late 2005, when the spread between the 10 year and the 3 month began to tighten.  I just read a very interesting paper that was pulbished in the Summer of 2006, by Jonathon Wright titled, The Yield Curve and Predicting Recessions.

In his paper, he argues that by looking at the levels that the Fed Funds rate is currently at, one could get a more accurate indication of whether or not a recession would follow.  The reason the level of interest rates is so important, is because at lower rates, there is a much smaller chance of a recession, while at higher interest rates, there is a much higher chance of a recession.

Econbrowser has a very good explanation of this in simple terms.  It also provides a link so that one could get a pretty good estimate of the probability of a recession by entering in both rates.

So where does this put us right now?  At a 5.25% interest rate, and a difference of -.43 between the two rates, we're at about a 50% chance of a recession with the 90 day average.  Yesterday the difference was -.60, which suggests that the odds are going to increase in the coming weeks.

And the market is finally beginning to react to this news.  The economy is NOT as strong as people had perceived.  Alan Greenspan has said multiple times in the last week, that there is a good chance of a recession in 2007.  I'm sure Ben Bernake is aware of the odds of a recession considering these studies are coming out of the Federal Reserve of New York.  Yesterday afternoon, Mr. Tomnitz, the CEO of DR Horton said housing will "suck" in 2007.

Hmm.