Magazine article Economic Trends

What Is the Yield Curve Telling Us? ... and Should We Have Listened?

Magazine article Economic Trends

What Is the Yield Curve Telling Us? ... and Should We Have Listened?

Article excerpt

02.01.10

A new year has started, and by some reckoning, a new decade, so it may be a natural time to take a look back. This column has been around for three years, giving a full two years of "year-ahead" predictions, and it's time assess those predictions. First, though, let's look at the story for this month.

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Since last month, the yield curve has moved up and gotten a bit steeper, with long rates rising a bit more than short rates. 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.

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Mote 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 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.

Since last month, the three-month rate has risen to 0.06 percent (for the week ending January 22), up from December's 0.04 percent, which was unchanged from November.

The 10-year rate increased to 3.66 percent, up from December's 3.56 percent and also from November's 3.35 percent. The slope increased to 360 basis points (bp), up from December's 352 bp and November's 331 bp. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.17 percent rate over the next year, down a bit from December's prediction of 1.62. Some of the change resulted from recalibrating the model with the latest real GDP numbers for the fourth quarter of 2009.

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Although the time horizons do not match exactly, this comes in on the more pessimistic side of other forecasts, although, like them, it does show moderate growth for the year.

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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. …

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