Since last month, the yield curve has dropped slightly, with both long and short rates ticking down. The difference between these rates, the slope of the yield curve, 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). In particular, 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.
Here is the chart of the yield curve spread and lagged GDP growth:
And here is a chart of the recession probability:
6 comments:
The only fly in the yield curve ointment is that it is impossible for the curve to invert when short rates are at zero. This problem also confounds the Leading Indicators, which I believe include slope or spread as one of their data points. I'd argue the yield curve is less useful as a forecasting tool when short rates are at the zero bound.
The current yield spread doesn't indicate a high probability for a recession but as anonymous indicates, the zero bound environement might be have a negative effect on the reliability of this leading indicator.
It's important to remember that the markets and things like the yield curve are ultimately driven by what millions of human beings think is going to happen. In any situation where those millions are in relative consensus, things like the yield curve have strong predictive power. In a situation like we have now, not so much.
So for example we had a yield curve inversion just before the dot com collapse. The bubble was clear, people knew it would eventually bust, it was more a matter of timing. So as we got closer to the bust point, people began to get skittish and flee to the treasury market. Thus the curve inverts and we have our prediction.
Right now though, there's a lot of uncertainty about which way we are heading. Therefore nobody's making large enough bets either way to really drive these indicators in a useful direction. There seems to be consensus around the fact that we are going to see slower growth in the short run, but it's not clear if it will become a down turn. Thus not enough people are convinced one way or the other such that indicators like the yield curve reveal much.
Right now, measures that largely ignore investor sentiment are going to be the most accurate. Things like the yield curve rely on the assumption that the market has a good idea of where it's going and frankly, it doesn't right now.
Anon at 11L43 and Constant Learner:
I agree with you. Take a look at the yield curve in late 2007 and early 2008. Its inversion ended in about October, and by january 08 it was steeply positive.
So, how were things in autumn 2008 and winter 2008-09?
Also, beginning from late 1929 until the early 1950s the yield curve never inverted. So, how were things in 1930-32 and 1938?
The 1930's were truly a different time corporate profits were 10.8 billion in 1929 collapsed to minus.2 in 1932 and didn't return to old
profits highs until 1941 at 15.5 billion. NIPA corporate profits
after tax have already returned to
their old hihs....
@ NDd :
Just as I said in an older exchange on one of your notes, there are recession indicators and recovery indicators. The inverted yield curve is a recession indicator. What's more, it has a 6-12 months lead.
What do you use to calculate the yield curve during the 1930s ? The proxies I choosed do show an inverted yield curve but they might not be the best ones.
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