What Is the Yield Curve Telling Us?...And Should We Have Listened?
A new year has started, and by some reckoning, a new decade, so it may be a natural time to take a look back. This column has been around for three years, giving a full two years of “year-ahead” predictions, and it’s time assess those predictions. First, though, let’s look at the story for this month.
Since last month, the yield curve has moved up and gotten a bit steeper, with long rates rising a bit more than short 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 10-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 has risen to 0.06 percent (for the week ending January 22), up from December’s 0.04 percent, which was unchanged from November.
The 10-year rate increased to 3.66 percent, up from December’s 3.56 percent and also from November’s 3.35 percent. The slope increased to 360 basis points (bp), up from December’s 352 bp and November’s 331 bp. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.17 percent rate over the next year, down a bit from December’s prediction of 1.62. Some of the change resulted from recalibrating the model with the latest real GDP numbers for the fourth quarter of 2009.
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 January is 5.1 percent, just down from December’s is 5.5 percent and just up from November’s 4.7 percent.
Now let’s take a look our track record. We’re going to skip the usual disclaimer about using these numbers at your own risk, because looking at past performance should make the point obvious.
First, let’s compare at our year-ahead forecasts of real GDP with the actual figures and the consensus predictions of the Blue Chip panel. We’ve made our predictions on a monthly basis, but GDP only comes out quarterly, so for the comparison we’ve taken quarterly averages. At the beginning, our yield curve model was predicting lower growth than Blue Chip, but neither predicted anything like the negative numbers seen in this recession. Blue Chip seemed to catch on to the length of the recession faster than the yield curve model, which seemed to expect a faster upturn.
The other prediction we make every month, on the probability of a recession, fares somewhat better, but shows a similar pattern. In December 2006, our yield curve model was predicting a 44 percent chance of recession in December 2007, which, as it turns out, is when the NBER eventually ended up dating the onset of the current recession. Many people think the recession ended in the third quarter of 2009, and our yield curve model put low odds on the recession continuing that long.
How about our brush with greatness, when Nobel Prize winner and New York Times columnist Paul Krugman thought we were too optimistic in December 2008? We predicted a year-over-year growth rate of 3 percent for December 2009. The actual number came out to be 0.1 percent—low, but positive. So perhaps we should call it a tie.
As usual, 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?"