May 9th, 2015
from the Cleveland Fed
Who knows if it was the Ides of March, the coming of spring, or something else, but the yield curve gave back some of its previous steepening and turned flatter. As has been typical lately, most of the action was mainly at the long end, while the short end inched upward with the three-month (constant maturity) Treasury bill rate rising to 0.03 percent (for the week ending March 20), up from February's 0.02 percent and level with January's still low 0.03 percent.
|3-month Treasury bill rate (percent)||0.03||0.02||0.03|
|10-year Treasury bond rate (percent)||2.00||2.11||1.85|
|Yield curve slope (basis points)||197||209||182|
|Prediction for GDP growth (percent)||2.1||2.1||2.1|
|Probability of recession in 1 year (percent)||4.85||4.12||5.97
The ten-year rate (also constant maturity) dropped 11 basis points to an even 2.00 percent, down from February's 2.11 percent, but still noticeably higher than January's 1.85 percent. These changes dropped the slope to 197 basis points, down 12 basis points from February's 209 basis points, but still up from January's 182 basis points.
The flatter slope did not have a large impact on predicted real GDP growth; expected growth stayed constant. Past values of the spread and GDP growth suggest that real GDP will grow at about a 2.1 percent rate over the next year, the same as the previous two months. The influence of the past recession continues to push towards relatively low growth rates, but recent stronger growth is counteracting that push. Although the time horizons do not match exactly, the forecast is slightly more pessimistic than some otherpredictions, but like them, it does show moderate growth for the year.
The flatter slope, however, had the usual effect on the probability of a recession, which decreased slightly. Using the yield curve to predict whether or not the economy will be in a recession in the future, we estimate that the expected chance of recession next March at 4.85 percent, up a bit from the February probability of 4.12 percent, though still lower than the January's figure of 5.97 percent. So although our approach is somewhat pessimistic with regard to the level of growth over the next year, it is quite optimistic about the recovery continuing.
The Yield Curve as a Predictor of Economic Growth
The slope of the yield curve - the difference between the yields on short- and long-term maturity bonds - 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. Yield curve inversions have preceded each of the last seven recessions (as defined by the NBER). One of the recessions predicted by the yield curve was the most recent one. 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.
Predicting GDP Growth
We use past values of the yield spread and GDP growth to project what real GDP will be in the future. We typically calculate and post the prediction for real GDP growth one year forward.
Predicting the Probability of Recession
While we can use the yield curve to predict whether future GDP growth will be above or below average, it does not do so well in predicting an actual number, especially in the case of recessions. Alternatively, we can employ features of the yield curve to predict whether or not the economy will be in a recession at a given point in the future. Typically, we calculate and post the probability of recession one year forward.
Of course, it might not be advisable to take these numbers 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?". Our friends at the Federal Reserve Bank of New York also maintain a website with much useful information on the topic, including their own estimate of recession probabilities.
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