The Yield Curve, October 2009
Since last month, the yield curve has shifted a bit downward and steepened slightly, with short rates dropping a bit faster than long rates. The difference between these rates, 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 ten-year Treasury bonds and three-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 three-month rate fell to 0.07 percent (for the week ending October 16), down from September’s 0.11 percent and below August’s 0.17 percent. The ten-year rate dropped to 3.43 percent, down 3 basis points from September’s 3.46 percent, and only 2 basis points below August’s 3.48 basis points. The slope increased 346 basis points, up from September’s 335 basis points, and August’s 331 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, the same prediction as last month, not surprising since the movement in rates was small. Although the time horizons do not match exactly, this comes in somewhat below other forecasts.
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 October stands at 3.9 percent, up from September’s 3.0 percent, which was in turn up from August’s 2.6 percent.
The probability of recession coming out of the yield curve is very low, but remember that the forecast is for where the economy will be in a year, not where it is now. However, 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.
Durations of Yield Curve Inversions and Recessions
|Recession||Yield curve inversion|
(before and during recession)
(through September 2009)
Note: Yield curve inversions are not necessarily continuous month-to-month periods.
Sources: Bureau of Economic Analysis; Federal Reserve Board; and authors’ calculations.
Of course, it might not be advisable to take these 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, they 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?".