The Yield Curve, November 2009
Since last month, the yield curve has shifted a bit downward and flattened slightly, with long rates dropping a bit faster than short rates. The difference between these two 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. 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 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.
Since last month, the three-month rate has fallen to 0.04 percent (for the week ending November 20). At that rate, $100 invested for a year would earn 4 cents. This is down from October's already very low 0.07 percent and September's 0.11 percent. The 10-year rate dropped to 3.35 percent, down a bit from October's 3.43 percent and September's 3.46 percent. The slope decreased to 331 basis points, down from October's 336 basis points and September's 335 basis points.
Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.6 percent rate over the next year. This is down from last month's prediction of 2.3 percent, and it is a rather large change, particularly since rates hardly moved. The difference resulted from re-estimating the model using more recent real GDP numbers. Although the time horizons do not match exactly, our estimate comes in somewhat below 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 November stands at 4.7 percent, up a bit from October's 3.9 percent and September's 3.0 percent, but it is still, of course, very low. The low probability accords with many forecasts that suggest we have already come out of recession. Remember, too, that the forecast is for where the economy will be in a year.
Of course, it might not be advisable to take these 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 those that generated yield spreads in 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, they 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?”