The Yield Curve, September 2008
Since last month, the yield curve has moved lower and gotten steeper, as both short and long-term interest rates fell. 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 Treasury bonds and 3-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.
The financial crisis showed up in the yield curve, with rates falling since last month, as investors fled to quality. This was particularly true at the short end, with the 3-month rate dropping from 1.86 percent all the way down to 0.62 percent (for the week ending September 19).
The 10-year rate took a substantial but less impressive drop from 3.91 to 3.52 percent. Consequently, the slope increased by a full 85 basis points, moving to 290 basis points up from the 205 basis points for August and well above the 213 basis points seen in July. The flight to quality and the turmoil in the financial markets may impact the reliability of the yield curve as an indicator growth, but projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 3.0 percent rate over the next year. This remains on the high side of other forecasts.
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 September stands a miniscule 0.2 percent, down from August's 1.3 percent and July's 1.1 percent.
The probability of recession is below several recent estimates and perhaps seems strange the in the midst of the recent financial concerns, but one aspect of those concerns has been a flight to quality which lowers Treasury yields. Furthermore, both the federal funds target rate and the discount rate have remained low, which tends to result in a steep yield curve. Remember also that the forecast is for where the economy will be next September, not earlier in the year.
To compare the 0.2 percent to some other probabilities, and learn more about different techniques of predicting recessions, head on over to the Econbrowser blog.
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?”