The Yield Curve as a Predictor of Economic Growth, March 2011
February 25, 2011 – March 25, 2011
|3-month Treasury bill rate (percent)||0.09||0.11||0.15|
|10-year Treasury bond rate (percent)||3.29||3.60||3.36|
|Yield curve slope (basis points)||320||349||321|
|Prediction for GDP growth (percent)||1.0||1.0||1.0|
|Probability of recession in 1 year (percent)||0.9||0.7||1.2|
Overview of the Latest Yield Curve Figures
Over the past month, the yield curve flattened, as long rates dropped sharply, reversing their pattern of the past several months. Short rates edged down yet again. The three-month Treasury bill rate moved down into the single-digit range, at 0.09 percent, down from February’s 0.11 percent, and January’s 0.15 percent. The ten-year rate dropped to 3.29 percent, down from February’s 3.60 percent, and even below January’s 3.36 percent. The slope dropped by a full 29 basis points, and is now just above January’s level of 321 basis points.
Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.0 percent rate over the next year, the same numbers as January and February. The strong influence of the recent recession is leading toward relatively low growth rates, with a steady beat of 1 percent predictions. Although the time horizons do not match exactly, the forecast comes in on the more pessimistic side of other forecasts, although, like them, it does show moderate growth for the year.
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 March is 0.9 percent, up slightly from February’s 0.7 percent and slightly down from January’s 1.2 percent.
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.
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 Commentary “Does 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.