The Yield Curve, December 2009
Since last month, the yield curve has gotten a bit steeper, with long rates moving up as short rates held steady. 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 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 held constant at 0.04 percent (for the week ending December 18). At that rate, 100 dollars invested for a year would earn 4 cents. This is down from October’s already very low 0.07 percent.
The 10-year rate increased to 3.56 percent, up from November’s 3.35 percent, and even above October’s 3.43 percent. The slope increased to 352 basis points, up from November's 331 basis points, and from October’s 336 basis points. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.62 percent rate over the next year. This is about equal to the 1.65 percent predicted last month. Although the time horizons do not match exactly, this month’s estimate 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 December is 5.5 percent, up a bit from November’s 4.7 percent, and from October’s 3.9 percent, but still, of course, very low.
The probability of recession coming out of the yield curve is low, and this accords with many forecasts that suggest we have already come out of recession—and remember that the forecast is for where the economy will be in a year.
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, 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?”