The Yield Curve, July 2009
Since last month, the yield curve has flattened slightly, with long rates dropping while short rates stayed essentially unchanged. The difference between these short and long 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 has held steady at a low 0.19 percent (for the week ending July 24), just up from June's 0.18 percent. The ten-year rate dropped to 3.62 percent, down 13 basis points from June's 3.75. The slope dropped to 343 basis points, down from June's 357 basis points, but still well above May's 296 basis points. Part of the increase may reflect a continuing reduction in financial market turmoil. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 2.6 percent rate over the next year. This is not that far from 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 July stands at a low 1.8 percent, just up from June's 0.8 percent, and even with May's 1.8 percent.
The probability of recession predicted by 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. Consider also 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 forecasts 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, 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.
Another way to get at the question of when the recovery will start is to compare the duration of past recessions with the duration of the preceding interest rate inversions. The table below makes the comparison for the recent period. The 1980 episode is anomalous, but in general, longer inversions tend to be followed by longer recessions. According to this pattern, the current recession is already longer than expected.
|Recession||Yield curve inversion
(before and during recession)
(through June 2009)
Note: Yield curve inversions are not necessarily continuous month-to-month periods.
Sources: 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?”