The Yield Curve, October 2007
Since last month, longer-term interest rates have increased with little movement in short rates, increasing the slope of the yield curve. 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 the increasingly steep curve, this is turning around. The spread remains robustly positive, with the 10-year rate at 4.67 percent and the 3-month rate at 4.00 percent (both for the week ending October 12). Standing at 67 basis points, the spread is up from September's 38 basis points and well above August's -4 basis points. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 2.4 percent rate over the next year. This is broadly in the range of other forecasts, if a bit on the low side.
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 14 percent, down from September's 17 percent and August's 28 percent.
Perhaps the decreasing probability of a recession seems strange in the midst of recent financial concerns, but one aspect of those concerns has been a flight to quality, which has lowered Treasury yields, and a reduction in both the federal funds target rate and the discount rate by the Federal Reserve, which tends to steepen the yield curve.
Our 14 percent chance is below 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 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?”