The Yield Curve, May 2009
Since last month, the yield curve has shifted up and gotten steeper, with both short and long rates rising. The spread between these rates, 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 seven recessions as defined by the (NBER). In particular, the yield curve inverted in August 2006, a bit more than a year before the current recession started in December 2007. There have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998.
More generally, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between ten-year Treasury bonds and three-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.
Since last month, the three-month rate edged upward from a low 0.13 percent to a barely higher 0.18 percent (for the week ending May 15). The ten-year rate increased from 2.96 percent to 3.14 percent. This increased the slope to 296 basis points, which is up from April's 283 basis points and well above March's 253. The flight to quality, the zero bound, and the turmoil in the financial markets may impact 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 2.9 percent rate over the next year. This is not that far from other forecasts.
While this 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 May stands at a very low 1.8 percent, just down from April's 1.9 percent, but above March's 1.1 percent.
The probability of recession coming out of the yield curve is very low, but remember that the forecast is for where the economy will be in a year, not where it is now. However, consider that 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.
Of course, it might not be advisable to take this number quite so literally, for two reasons. (Not even counting Paul Krugman's concerns.) First, the 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.
Another use the yield curve can serve is to get at the question of when the recovery will start. If we compare the duration of past recessions with the duration of the interest rate inversions that preceded them, we see that, with the exception of the 1980 recession, longer inversions have been followed by longer recessions. Given this pattern, the current recession is already longer than expected.
|Recession||Yield curve inversion
(before and during recession)
(through April 2009)
Note: Yield curve inversions are not necessarily continuous month-to-month periods.
Source: Bureau of Economic Analysis; Federal Reserve Board; and authors' calculations.
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?”