The Yield Curve
A look at the yield curve and why it is said to be the most accurate forecast of looming recession.
I have written about the yield curve more than any other single topic in the almost six years of writing. There is a justifiable reason to pay attention to the yield curve. In certain very specific circumstances, it has been the single most reliable predictor of recessions. Let's examine what those circumstances are.
First, the yield curve is a graphic depiction of the relationship between the yield on bonds of the same credit quality but different maturities. Normally, you expect to get more interest paid to you for holding a longer maturity, as in theory there is more risk to holding a bond for ten years than for 90 days, or for 30 years as opposed to a mere ten years. You can go to http://www.bloomberg.com/markets/rates/index.html and see an up-to-the-minute graph on the yield curve for US treasuries. At 4:00 pm Eastern time on December 30 2005 it looked like this:
This is of course highly unusual. Most of the time the curve or graph will start in the lower left and rise to the upper right. Today it sags in the middle, which means that yields on the two year note is paying more than the ten year bond.
When a shorter maturity note pays more than a longer maturity note or bond, the curve is said to be inverted. There are times when the entire yield curve goes from the upper left to then lower right on the graph. When this happens the yield curve is said to be fully inverted. As we will see below, how far the yield curve inverts gives us a percentage probability of the likelihood of a recession within 4-6 quarters. So, we pay attention to this curve.
Now, let's review a little history. Professor Campbell Harvey of Duke was the one that wrote about the relationship between recessions and the yield curve, and proved that the yield curve outperformed other forecasting tools in his 1986 dissertation at the University of Chicago. He published his dissertation in 1988 in the Journal of Financial Economics. In 1989, he published a follow up piece in the Financial Analysts Journal. Estrella (we'll read more about him later) and Hardouvelis picked up on the idea and published an article in 1989 and a few more.
Harvey's prediction about the usefulness of the yield curve was right on target. In 1991, after the 1990 recession he noted that inversions of the yield curve (short-term rates greater than long term rates) have preceded the last five US recessions, suggesting that the curve can accurately forecast the turning points of the business cycle.
Fast forward to 1996. Arturo Estrella and Frederic S. Mishkin, economists for the New York Federal Reserve Bank, wrote an article in the "Current Issues in Economics and Finance" which is published by the New York Federal Reserve Bank. In it, they compare the usefulness of the yield curve as a prediction tool to other indicators:
"The yield curve--specifically, the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill--is a valuable forecasting tool. It is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead."
They compared the yield curve with three other possible indicators, including the so called "leading economic indicators" from the Conference Board. The only reliable predictor four quarters out was the yield curve spread.
In September 2000 the yield curve was seriously inverting. I called Estrella to talk about the importance of the curve. I wrote then:
"First, he told me he had done another study in 1998 comparing even more predictors. The latest study involved 30 potential predictors of a recession. The conclusion of that study is that the 90 day average of the yield curve was the most reliable predictor of the 30 they studied, so score one for taking this current situation more seriously."
The paper that they published used the spread between the 90 day T-bill and the ten year bond. For the record, the average ten year bond since 1982 has yielded 7.31%, the average 90 day T-bill was 5.49% and the average spread was 1.82%. For the record, today we have the 90 day at 4.08%, the ten year at 4.39% for a difference of 0.31%.
They used the 90 day average of the spread rather than the actual one day spread. This is important. There are several times where the yield curve inverted for a few days but did not stay that way for long. Recessions did not follow.