The Yield Curve and Predicted GDP Growth, September 2014
October 2, 2014
Covering August 23, 2014–September 19, 2014
Highlights

September

August

July

3month Treasury bill rate (percent)  0.02  0.03  0.03 
10year Treasury bond rate (percent)  2.61  2.41  2.49 
Yield curve slope (basis points)  259  238  246 
Prediction for GDP growth (percent)  1.5  1.5  1.5 
Probability of recession in 1 year (percent)  1.99  2.76  2.46 
Overview of the Latest Yield Curve Figures
Since last month, the yield curve shifted sharply, steepening with long rates rising while the short end stayed (nearly) constant. The threemonth (constant maturity) Treasury bill rate edged down to 0.02 percent (for the week ending September 19) from July’s and August’s levels of 0.03 percent. The tenyear rate (also constant maturity) increased to 2.61 percent, up a full 20 basis points from August’s 2.41 percent, nearly recovering previous drops from June’s 2.63 percent. The slope increased to 259 basis points, up from August’s 241 basis points, and only 1 basis point below June’s 260 basis points.
The steeper slope did not have an appreciable change on predicted future growth, even using the revised third estimate, which pushed the estimated growth from real GDP in the second quarter up to 4.6 percent from the previous estimate of 4.2 percent (both annualized). Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.5 percentage rate over the next year, even with the forecasts from July and August (and just up from the 1.4 percent forecast in June). The influence of the past recession continues to push towards relatively low growth rates. Although the time horizons do not match exactly, the forecast comes in slightly more pessimistic than some other predictions, but like them, it does show moderate growth for the year.
The steeper slope dropped the probability of a recession below 2 percent. Using the yield curve to predict whether or not the economy will be in a recession in the future, we estimate that the expected chance of the economy being in a recession next September at 1.99 percent, down from the August number of 2.76 percent, below July’s 2.46 percent, and returning to the level last seen in June. So although our approach is somewhat pessimistic with regard to the level of growth over the next year, it is quite optimistic about the recovery continuing.
The Yield Curve as a Predictor of Economic Growth
The slope of the yield curve—the difference between the yields on short and longterm maturity bonds—has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last seven recessions (as defined by the NBER). One of the recessions predicted by the yield curve was the most recent one. The yield curve inverted in August 2006, a bit more than a year before the current recession started in December 2007. There have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998.
More generally, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between tenyear Treasury bonds and threemonth Treasury bills, bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it.
Predicting GDP Growth
We use past values of the yield spread and GDP growth to project what real GDP will be in the future. We typically calculate and post the prediction for real GDP growth one year forward.
Predicting the Probability of Recession
While we can use the yield curve to predict whether future GDP growth will be above or below average, it does not do so well in predicting an actual number, especially in the case of recessions. Alternatively, we can employ features of the yield curve to predict whether or not the economy will be in a recession at a given point in the future. Typically, we calculate and post the probability of recession one year forward.
Of course, it might not be advisable to take these numbers quite so literally, for two reasons. First, this probability is itself subject to error, as is the case with all statistical estimates. Second, other researchers have postulated that the underlying determinants of the yield spread today are materially different from the determinants that generated yield spreads during prior decades. Differences could arise from changes in international capital flows and inflation expectations, for example. The bottom line is that yield curves contain important information for business cycle analysis, but, like other indicators, should be interpreted with caution. For more detail on these and other issues related to using the yield curve to predict recessions, see the Commentary “Does the Yield Curve Signal Recession?” Our friends at the Federal Reserve Bank of New York also maintain a website with much useful information on the topic, including their own estimate of recession probabilities.