The Yield Curve, May 2010
Since last month, the yield curve has flattened, with long rates falling as short rates barely ticked up. 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 three-month rate rose to 0.17 (for the week ending May 21), up a mere 1 basis point from April’s 0.16 percent. The 10-year rate took a fairly sizeable drop to 3.33 percent from April’s 3.85 percent. This dropped the slope to 316 basis points, still high, but a drop of 53 basis points from April’s 369 basis points.
Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 0.98 percent rate over the next year, a bit below April’s 1.17 percent. Although the time horizons do not match exactly, this comes in on the more pessimistic side of other forecasts, although, like them, it does show moderate growth for the year.
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 May is 9.9 percent, up from the April number of 7.1 percent. This should not be too surprising, given the drop in the spread.
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?"