Magazine article Economic Trends

The Yield Curve, October 2008

Magazine article Economic Trends

The Yield Curve, October 2008

Article excerpt

10.24.08

In the midst of the horrendous economic news of the past month, the yield curve might provide a slice of optimism. On the other hand, the historic turmoil in the financial markets also suggests that historical relations may not be holding up in times of stress. Since last month, the yield curve has gotten steeper, as short rates fell and long-term rates rose.

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One reason for noting this is that 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 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 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.

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 0.62 percent to 0.46 percent (for the week ending October 17).

Meanwhile, the 10-year rate rose from 3.52 percent all the way up to 4.06 percent. Consequently, the slope increased by a full 66 basis points, moving to 356 basis points, up from the 290 basis points for September and the 205 basis points for August. The flight to quality and the turmoil in the 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 3.0 percent rate over the next year. This remains on the high side of other forecasts, many of which are predicting reductions in real GDE

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 October stands a miniscule 0. …

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