The Yield Curve and Predicted GDP Growth, August 2016
Covering July 23—August 19, 2016
|3-month Treasury bill rate (percent)||0.30||0.32||0.28|
|10-year Treasury bond rate (percent)||1.56||1.58||1.68|
|Yield curve slope (basis points)||126||126||140|
|Prediction for GDP growth (percent)||1.5||1.5||1.7|
|Probability of recession in 1 year (percent)||11.25||11.28||9.58|
Overview of the Latest Yield Curve Figures
The dog days of August saw the yield curve taking a small parallel shift upward, with both short and long rates inching down. The three-month (constant maturity) Treasury bill rate decreased 2 basis points to 0.30 (for the week ending August 19), down two basis points from July’s 0.32 and just up from June’s 0.28. The ten-year rate (also constant maturity) dropped 2 basis points to 1.56, down from July’s 1.58 percent and a full 12 basis points below June’s 1.68 percent. The slope stayed level at July’s 126 basis points, which was a noticeable decline from June’s 140 basis points.
With no change in the spread, the impact on predicted real GDP growth was minimal. Using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.5 percent rate over the next year, even with the July number, and down a bit from the 1.7 percent seen in June. Although the time horizons do not match exactly, the forecast is at a similar level as other forecasts, and like them, it does show moderate growth for the year.
Not surprisingly, the probability of recession didn’t move much either. Using the yield curve to predict whether or not the economy will be in recession in the future, we estimate the expected chance of the economy being in a recession next August at 11.25 percent, just below July’s 11.28 percent, which was up from June’s estimate of 9.58 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. (For a recent example, see the “Recessions Probabilities.”) 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.