The Yield Curve and Predicted GDP Growth, December 2016
Covering November 26—December 16, 2016
|3-month Treasury bill rate (percent)||0.52||0.49||0.34|
|10-year Treasury bond rate (percent)||2.54||2.34||1.76|
|Yield curve slope (basis points)||202||185||142|
|Prediction for GDP growth (percent)||1.6||1.5||1.4|
|Probability of recession in 1 year (percent)||4.07||5.88||9.24|
Overview of the Latest Yield Curve Figures
As we approach the end of the year, the yield curve has continued its shift upwards. In doing so it also continued the trend of getting steeper, for while both short and long rates moved up, the short rate increase of 3 basis points was overshadowed by the 20 basis point rise in the long rate. The three-month (constant maturity) Treasury bill rate increased to 0.52 percent (for the week ending December 16), up from November’s 0.49 percent and from October’s 0.34 percent and more than double September’s 0.24 percent. The ten-year rate (also constant maturity) rose to 2.54 percent, a good jump up from November’s 2.34 percent, though not quite the earlier jump from November to October of 1.76 percent. These changes increased the slope to 202 basis points, up 17 basis points from November’s185 basis points and a full 60 basis points from October’s 142 basis points.
The jump in the spread had a surprisingly small impact on predicted real GDP growth, in part because there was a new GDP growth estimate for the third quarter of 3.5 percent. 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, just above November’s estimate (1.5 percent) and October’s (1.4 percent). Although the time horizons do not match exactly, the forecast is perhaps a bit below other forecasts, though like them, it does show moderate growth for the year.
The probability of recession showed a larger move, decreasing substantially from an already low level. 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 December at 4.07 percent, down from November’s 5.88 percent, itself a big drop from the October number of 9.24 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.