The Yield Curve, November 2008
In the midst of the horrendous economic news of the last month, the yield curve might provide a slice of optimism. Since last month, it has flattened, as short rates fell more than long rates. On the other hand, the historic turmoil in the financial markets also suggests that the historical relationships on which our interpretation of the yield curve depends may not be holding up in times of stress.
Those relationships underlie the use of the slope of the yield curve 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 six recessions (as defined by the NBER ). Very flat yield curves preceded the previous two, and there have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998. More generally, though, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between 10-year bonds and 3-month T-bills, bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it.
The financial crisis showed up in the yield curve, with short rates falling since last month, as investors fled to quality. The 3-month rate dropped from an already low 0.46 percent down to a miniscule 0.07 percent (for the week ending November 21), the lowest level it has been since the Treasury constant maturity series started in 1982.
The 10-year rate fell from 4.06 percent to 3.38 percent. Consequently, the slope decreased by 29 basis points to 331, down from 360 in October, but still above the 290 basis points for September and the 205 for August.
The flight to quality and the turmoil in the financial markets may affect the reliability of the yield curve as an indicator, but projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 3.4 percent rate over the next year. This remains on the high side of other forecasts, many of which are predicting reductions in real GDP.
While such an approach can predict when growth is above or below average, it does not do so well in predicting the actual number, especially in the case of recessions. Thus, it is sometimes preferable to focus on using the yield curve to predict a discrete event: whether or not the economy is in recession. Looking at that relationship, the expected chance of the economy being in a recession next November stands a miniscule 0.05 percent, equal to October and down from September's already low 0.2 percent.
The probability of recession predicted by the yield curve is very low, and may seem strange the in the midst of the recent financial news, but one aspect of those concerns has been a flight to quality, which lowers Treasury yields. Furthermore, both the federal funds target rate and the discount rate have remained low, which tends to result in a steep yield curve. Remember also that the forecast is for where the economy will be next November, not earlier in the year. On the other hand, in the spring of 2007, the yield curve was predicting a 40 percent chance of a recession in 2008, something that looked out of step with other forecasters at the time.
To compare the 0.05 percent to some other probabilities and learn more about different techniques of predicting recessions, head on over to the Econbrowser blog. It might not be advisable to take this 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?”