Magazine article Economic Trends

The Yield Curve, April 2009

Magazine article Economic Trends

The Yield Curve, April 2009

Article excerpt

04.29.09

Since last month, the yield curve has twisted steeper, with short rates dropping and long rates rising. The difference between short and long 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.

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More generally; a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between 10-year Treasury bonds and 3-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.

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Since last month the 3-month rate edged downward from an already low 0.22 percent to an even lower 0.13 percent (for the week ending April 24). The 10-year rate increased from 2.75 percent to 2.96. This increased the slope to 283 basis points, a full 30 points higher than March's 253 basis points, and well above February's 258 basis points.

The flight to quality, the zero bound, and the turmoil in financial markets may impact 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 rate of 3.0 percent over the next year. This remains on the high side of other forecasts, many of which expect slower growth real GDP.

While such an approach predicts 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 April stands at a very low 1.9 percent, up a bit from March's 1.1 percent and February's 0. …

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