The Yield Curve, August 2007
Since last month, the yield curve has twisted downward, with long rates falling more than short rates. This has once again returned the curve to inversion. One reason for noting this is that 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 six recessions (as defined by the NBER). Very flat yield curves preceded the previous two, and there have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998. 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 had been giving a rather pessimistic view of economic growth for a while now, but with a nearly flat curve, this is less pronounced. The spread has turned negative with the 10-year rate at 4.79 percent and the 3-month rate at 4.83 percent (both for the week ending August 10). Standing at -4 basis points, the spread is down from July's 14 basis points and June's 54 basis points, though it remains not nearly as inverted as May's -23 basis points. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 2.1 percent rate over the next year. This prediction is on the low side of other forecasts, in part because the quarterly average spread used here remains negative.
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 28 percent, up from July's 24 percent, but still down from May's value of 35 percent and April's 38 percent.
The current 28 percent is close to the 26.2 percent calculated by James Hamilton over at Econbrowser (though to be fair, we are calculating different events: Our number gives a probability that the economy will be in recession over the next year; Econbrowser looks at the probability that the first quarter of 2007 was in a recession).
Of course, it might not be advisable to take these numbers quite so literally, for two reasons. First, probabilities are themselves 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?”