The Yield Curve, September 2007
Since last month, turmoil in the financial market has shifted the yield curve downward, with short rates falling by more than long rates. The yield curve has returned to its normal upward slope after its brief dip into inversion last month.
Market watchers attend to the slope of the yield curve because it 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 turned positive, with the 10-year rate at 4.42 percent and the 3-month rate at 4.04 percent (both for the week ending September 14). Standing at 38 basis points, the spread is up from August's -4 basis points and July's 14 basis points but still below June's 54 basis point spread. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 2.2 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 includes some earlier inversions.
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 17 percent, down from August's 28 percent and July's 24 percent.
Perhaps these observations seems strange in the midst of recent financial concerns, but two developments explain the current shape of the yield curve and its implications. First, the financial concerns have caused a flight to quality, which works to lower Treasury yields. Second, the Federal Reserve has reduced both the federal funds target rate and the discount rate, and these lower rates tend to steepen the yield curve.
The 17 percent probability of a recession in the next year is below the 26.2 percent calculated by James Hamilton over at Econbrowser. (Note that Econbrowser is calculating a different event. Our number gives a probability that the economy will be in recession over the next year; Econbrowser looks at the probability that the quarter 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?”