The Yield Curve and Predicted GDP Growth, December 2015
November 21—December 18, 2015
|3-month Treasury bill rate (percent)||0.24||0.13||0.05|
|10-year Treasury bond rate (percent)||2.25||2.26||2.11|
|Yield curve slope (basis points)||201||213||206|
|Prediction for GDP growth (percent)||1.9||1.9||1.9|
|Probability of recession in 1 year (percent)||4.42||3.74||4.21|
Overview of the Latest Yield Curve Figures
Well, the FOMC raised the target federal funds rate from the floor range of 0–25 basis points to 25–50 basis points. What did it mean for the yield curve? The curve pivoted higher around the long end, getting slightly flatter in the process. The three-month (constant maturity) Treasury bill rate apparently followed the risk in the fed funds rate, rising to 0.25 percent (for the week ending December 18), up from November’s 0.13 percent and well above October’s 0.05 percent. The ten-year rate (also constant maturity) dropped to 2.25 percent, a meager 1 basis point below November’s 2.26 percent, though a bit above October’s 2.11 percent. The tilt lowered the spread to 201 basis points, down from both November’s 213 basis points and October’s 206 basis points.
The flatter slope did not have a large impact on predicted real GDP growth as expected growth stayed steady. Using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.9 percent rate over the next year, even with rates in November and October. The influence of the past recession continues to push towards relatively low growth rates, but recent year-over-year growth has been stronger (particularly in 2015:Q2) and is counteracting that push. Although the time horizons do not match exactly, the forecast is similar to other forecasts, and like them, it does show moderate growth for the year.
The flatter slope led to a small increase in the probability of recession. 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 December at 4.42 percent, up just a bit from the November number of 3.74 percent, as well as the October number of 4.21 percent. So the yield curve is optimistic about the recovery continuing, even if it is somewhat pessimistic with regard to the pace of growth over the next year.
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 numbers 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.