# Yield curve and predicted GDP growth, May 2013.

Covering April 16, 2012-May 20, 2013

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Overview of the Latest Yield Curve Figures

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, and 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.

The slope change had a bit more impact on the probability of a recession. Using the yield curve to predict whether or not the economy will be in recession in the future, we estimate that the expected chance of the economy being in a recession next May is 6.1 percent, down from April's 8.1 percent, though up a bit from March's 5.9 percent. So although our approach is somewhat pessimistic as regards 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

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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, and 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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For more on the yield curve, read the Economic Commentary "Does the Yield Curve Signal Recession?" at http://www.clevelandfed.org/Research/Commentary/2006/0415.pdf.

For more on the Federal Reserve Bank of New York's estimate fo recession, visit http://www.newyorkfed.org/research/capital_markets/ycfaq.html.

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Overview of the Latest Yield Curve Figures

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, and 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.

The slope change had a bit more impact on the probability of a recession. Using the yield curve to predict whether or not the economy will be in recession in the future, we estimate that the expected chance of the economy being in a recession next May is 6.1 percent, down from April's 8.1 percent, though up a bit from March's 5.9 percent. So although our approach is somewhat pessimistic as regards 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

[GRAPHIC OMITTED]

[GRAPHIC OMITTED]

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, and 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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For more on the yield curve, read the Economic Commentary "Does the Yield Curve Signal Recession?" at http://www.clevelandfed.org/Research/Commentary/2006/0415.pdf.

For more on the Federal Reserve Bank of New York's estimate fo recession, visit http://www.newyorkfed.org/research/capital_markets/ycfaq.html.

Highlights May April March Three-month Treasury bill rate (percent) 0.04 0.06 0.10 Ten-year Treasury bond rate (percent) 1.93 1.73 2.04 Yield curve slope (basis points) 189 167 194 Prediction for GDP growth (percent) 0.3 0.5 0.5 Probability of recession in one year 6.1 8.1 5.9 (percent) Sources: Board of Governors of the Federal Reserve System; authors' calculations

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Title Annotation: | Monetary Policy |
---|---|

Author: | Haubrich, Joseph G.; Waiwood, Patricia |

Publication: | Economic Trends |

Date: | Jun 1, 2013 |

Words: | 855 |

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