The Yield Curve, March 2007
As mentioned in previous months, 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. More generally, though, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between 10-year bonds and 3-month T-bills, bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it.
The yield curve has been giving a rather pessimistic view of economic growth for a while now. The spread is currently negative: With the 10-year Treasury note rate at 4.78 percent, and the 3-month Treasury bill rate at 5.07 percent (both for the week ending March 16), the spread stands at a negative 29 basis points, and indeed has been in the negative range since August. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.7 percent rate over the next year. This prediction is well below many other forecasts. On the other hand, the recent woes in the subprime mortgage industry are making pessimism a bit more fashionable these days.
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 a recession in the next year is 46 percent, up a bit from last month's value of 42 percent.
Of course, it might not be advisable to take this number quite so literally, for two reasons. 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?”