Why is the inverted yield curve a good predictor of impending economic recession? The inverted yield curve has often been cited as a good predictor of impending economic recession. What are the reasons to explain why is it a good predictor? Is the inverted yield curve a cause or symptom of recession?
There is a fair amount of ambiguity to this question. The first question is: what is the yield curve? A fixed income investor may refer to the yields across all maturities as the yield curve, while economists pick the difference in yields between two arbitrary maturities as the yield curve. Which two? Typical choices are the spread between the 2-year and 10-year bond, or the spread between the 3-month Treasury bill rate and the 10-year. The quality of a recession indicator depends which pair you choose.

The second question is: what country are we talking about? The yield curve is often described as a good recession indcator for the United States (which can be seen by looking at the time series of the 2-year/10-year Treasury spread, and compare them to recession dates. It is less clear how well it works for other countries.

There is a simple theoretical reason why it works. Under any modern financial model of the risk-free interest rate curve, we can see that term interest rates are roughly equal to the average of the expected overnight rate to its maturity, plus a term premium. (Technically, the average is a geometric average, since we are compounding an investment at the overnight rate.) As long as the term premium is not significantly negative, an inverted yield curve implies that the expected path of short-term rates is heading lower. The usual reason for a central bank to cut rates significantly is a recession (either domestically, or in trading partners).

In other words, if an inverted yield curve is a good recession indicator, it is just telling us that bond investors may be good at forecasting recession odds. Do we have reason to expect that they are perfect forecasters? Probably not. There’s any number of things that could distort bond market pricing, or else bond investors could herd into a poor forecast. Attempting to do statistical analysis of the yield curve without taking into account the changing institutional structure of the bond market is problematic.

I am not aware of any reason that suggests the inverted yield curve causes recessions under current institutional arrangements. (I am admittedly biased.) This is because developed country banking systes have much tighter control of interest rate risk now. This was not the case earlier (e.g., 1970s), and it may be that for some countries now, interest rate risk is not being hedged.

If you are interested in that question, I suggest asking it in a separate question, and you should specify what countries and eras you are interested in. The title of the question refers to prediction; a lot of readers would not relate that to causing recessions.