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Yield Curve and Predicted GDP Growth, August 2010

July 23, 2010–August 26, 2010

Highlights

August July June
3-month Treasury bill rate (percent) 0.16 0.16 0.09
10-year Treasury bond rate (percent) 2.61 2.97 3.26
Yield curve slope (basis points) 245 281 317
Prediction for GDP growth (percent) 1.0 1.14 1.0
Probability of recession in 1 year (percent) 18.5 15.5 12.4

Overview of the Latest Yield Curve Figures

As long rates continue their steep slide, the yield curve has flattened, as short rates stayed level. The three-month Treasury bill rate stayed at 0.16 percent, equal to July’s, and up from June’s 0.09 percent. The ten-year rate dropped to 2.61 percent, down from July’s 2.97 and well below June’s 3.26 percent. The slope dropped a full 36 basis points to 245, down from July’s 281, and well below the June number of 317 basis points.

Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.00 percent rate over the next year, just down from July’s 1.14 percent and equal to June’s prediction of 1.00 percent. Although the time horizons do not match exactly, this comes in on the more pessimistic side of other forecasts, although, like them, it does show moderate growth for the year.

Yield Curve Predicted GDP Growth

Using the yield curve to predict whether or not the economy will be in recession in the future, we estimate that the expected chance of the economy being in a recession next August rises to 18.5 percent, not surprising given the flattening in the spread. This estimate is up from the 15.5 percent for July and the 12.4 percent for June.

Recession Probability from Yield Curve

The Yield Curve as a Predictor of Economic Growth

The slope of the yield curve—the difference between the yields on short- and long-term maturity bonds—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). One of the recessions predicted by the yield curve was the most recent one. 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.

Yield Curve Spread and Real GDP Growth
Yield Curve Spread and Lagged Real GDP Growth

Predicting GDP Growth

We use past values of the yield spread and GDP growth to project what real GDP will be in the future. We typically calculate and post the prediction for real GDP growth one year forward.

Predicting the Probability of Recession

While we can use the yield curve to predict whether future GDP growth will be above or below average, it does not do so well in predicting an actual number, especially in the case of recessions. Alternatively, we can employ features of the yield curve to predict whether or not the economy will be in a recession at a given point in the future. Typically, we calculate and post the probability of recession one year forward.

Of course, it might not be advisable to take these 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 CommentaryDoes the Yield Curve Signal Recession?” Our friends at the Federal Reserve Bank of New York also maintain a website with much useful information on the topic, including their own estimate of recession probabilities.

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