What Is the Yield Curve Telling Us?
Since last month, the yield curve has flattened, with short rates rising and long rates falling. Even so, long rates remain higher than short rates, and the movement was not enough to return the curve to inversion. One reason for noting this is that 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.
The yield curve had been giving a rather pessimistic view of economic growth for a while, but with the inversion gone, this view is less pronounced. The spread has turned positive, with the 10-year rate at 5.10 percent and the 3-month rate at 4.96 percent (both for the week ending July 13). The spread stands at 14 basis points, down considerably from June's 54 basis points, but still well above May’s negative 23 basis points. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 2.3 percent rate over the next year. This prediction is on the low side of other forecasts, in part because the quarterly average spread used here remains negative.
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 24 percent, up from June’s 15 percent, but still down from May’s value of 35 percent and April’s 38 percent.
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?”