The Yield Curve, December 2008
In the midst of the horrendous economic news of the last month, the yield curve might provide a slice of optimism. Though the yield curve has flattened since November, with long rates falling more than short rates, the difference between the rates remained strongly positive.
This difference, 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. Yield curve inversions have preceded each of the last seven recessions (as defined by the NBER ), the current recession being a case in point. The yield curve inverted in August 2006, a bit more than a year before the recession started in December 2007. Two notable false positives include an inversion in late 1966 and a very flat curve in late 1998. More generally, a flat curve indicates weak growth, and conversealy, 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. The 3-month rate dropped from an already tiny 0.07 percent down to a miniscule 0.02 percent (for the week ending December 12), the lowest level since the Treasury constant maturity series started in 1982.
The 10-year rate dropped from 3.38 percent to 2.67 percent. Consequently, the slope decreased by 66 basis points to 265 basis points, down from November's 331, and October's 360. The flight to quality and the turmoil in the financial markets may affect the reliability of the yield curve as an indicator, 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, many of which are predicting reductions in real GDP.
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 December stands at a low 0.5 percent, up a bit from November's miniscule 0.05 percent.
Loyal readers may note the chart above looks a bit different this month; with the NBER declaring a recession, the model now has additional recession points to work with.
The probability of recession coming out of the yield curve is very low and may seem strange in the midst of recent financial news, 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 December, not earlier in the year. Again, though, in the spring of 2007, the yield curve was predicting a 40 percent chance of a recession in 2008, something that looked out of step with other forecasters at the time.
To compare the 0.5 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?”