The Yield Curve, February 2009
In the midst of all the depressing news about the economy, the yield curve still might provide a slice of optimism. The yield curve has gotten steeper since last month, with long rates rising more than short rates, and the difference between them remains strongly positive.
This difference, 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 seven recessions (as defined by the NBER). In particular, 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 10-year Treasury bonds and 3-month 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.
Since last month, the 3-month rate edged up from a tiny 0.11 percent to a still low 0.30 percent (for the week ending February 13). The 10-year rate increased from 2.67 percent to 2.88. This increased the slope to 258 basis points, up from January’s 237 basis points, but down a bit from December’s.
The flight to quality, the zero bound, and the turmoil in the financial markets may impact the reliability of the yield curve as an indicator, but projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 3.3 percent rate over the next year. This remains on the high side of other forecasts, many of which are predicting reductions in real GDP.
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 the economy being in a recession next February stands at 0.98 percent, down slightly from January’s 1.11 percent.
The probability of recession coming out of the yield curve is very low, and may seem strange in the midst of recent financial news, but one aspect of those concerns has been the flight to quality, which lowers Treasury yields. Furthermore, both the federal funds target rate and the discount rate have remained low, which tends to result in a steep yield curve. Remember that the forecast is for where the economy will be in a year, not where it is now, and consider that in the spring of 2007, the yield curve was predicting a 40 percent chance of a recession in 2008, something that looked out of step with other forecasters at the time.
To compare the 0.97 percent to what some other economists are predicting, head on over to the Wall Street Journal survey.
Of course, it might not be advisable to take this number quite so literally, for two reasons. (Not even counting Paul Krugman’s concerns). 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? "