Meet the Author

Joseph G. Haubrich |

Vice President and Economist

Joseph G. Haubrich

Joseph Haubrich is a vice president and economist at the Federal Reserve Bank of Cleveland, where he is responsible for leading the Research Department's Banking and Financial Institutions Group. He specializes in research related to financial institutions and regulations.

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Meet the Author

Brent Meyer |

Economist

Brent Meyer

Brent Meyer is a former economist of the Federal Reserve Bank of Cleveland.

01.16.07

Economic Trends

What Is the Yield Curve Telling Us?

Joseph G. Haubrich and Brent Meyer

The slope of the yield curve 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 six recessions (as defined by the NBER). Very flat yield curves preceded the previous two, and there have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998. More generally, though, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between 10-year bonds and 3-month T-bills, bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it.

Yield Spread versus Real GDP Growth

*Shaded areas represent recessions.
Sources: Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal Reserve System.

Yield Spread versus One-Year-Lagged Real GDP Growth

Sources: Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal Reserve System.

Lately, the yield curve has some forecasters worried. One reason for concern is that the spread is currently negative: with 10-year rate at 4.66 percentand the 3-month rate at 5.05 percent(both for the week ending January 5), the spread stands at a negative 39 basis points, and indeed has been in the negative range since August. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.6 percentrate over the next year.

Yield Spread Versus Predicted GDP Growth

Sources: Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal Reserve System.

While such an approach predicts when growth is above or below average, it does not do so well in predicting the actual number, especially in the case of recessions. Thus, it is sometimes preferable to focus on using the yield curve to predict a discrete event: whether or not the economy is in recession. Looking at that relationship, the expected chance of a recession in the next year is 43 percent.

UPDATE (02.01.07): Of course, it might not be advisable to take this number 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?"

Probability of Recession Based on Yield Spread*

*Estimated using probit model.
Sources: Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal Reserve System.