Many sophisticated measurements have been devised to predict the rate of U.S. economic growth. Some, like the government's Index of Leading Economic Indicators, have had success as a predicting tool. Yet none have the track record for predictive accuracy as has the yield curve.
A yield curve is the simple plotting of current U.S. Treasury yields - those yields can be found here at Momentum Investor daily. Plotting the yield sounds easy enough, right? It is. The graph created is arranged with the short-term rates on the left, extending to the long-term bonds on the right.
The yield curve shows two things. First, the yield curve demonstrates the overall level of current interest rates. This can be compared to previous charts to show how high current rates are relative to historical rates. Basically though, the historical comparison is of little use.
The best use of the yield curve graph is to determine the shape of the graph. The shape can tell us a lot about investor expectations for future interest rate movements, which in turn, often predict the rate of U.S. economic growth.
The shapes plotted in the yield curve can be Normal, Flat, Steep or Inverted.
Normal Yield Curves
A normal curve, as the name implies, is the shape most often found when yields are plotted. This shape is lower on the left, and higher on the right. It shows that short-term interest rates yield less than long-term interest rates. Here's an example:
As you can see from the chart above, December 1996 had a normal yield curve. A solid economic expansion occurred for the economy during the following year.
A normal yield curve is a moderate rise from short maturity to long - often about 2.5 percentage points from the bills to the long bond. The upslope of the curve represents investor's expectations of a normal growth cycle in the economy. Short-term bonds yield less than long-term bonds because investors need a higher yield to offset the risk that they are taking in locking themselves into a longer-term debt instrument. That stands to reason, since it is much easier to predict what might happen in the next 3 months, than predicting the next 30 years.
Flat Yield Curves
A flat yield curve occurs when the maturities of both short and long term maturities have nearly the same yield. Flattening curves may be a precursor to the ominous inverted curve (see below). When all maturities have approximately the same yield, the economy could potentially move into a pullback, or even a recession.
In the chart above, year-end 1989 rates were nearly equal across all maturities. Without confirmation from a slowing Gross Domestic Product, a flat yield curve is a mixed signal. However, in late 1990 and early 1991, the U.S. economy did move into a recession.
A flattened yield curve can represent one of two things: rising short-term rates, or falling long-term rates. Either way, expectations from a flat curve represent slowing real growth in the near term.
Inverted Yield Curves
An inversion of the yield curve results when investors rush to lock in long term bond rates. The price of the bond goes up, and the yield goes down. Why does this happen? It reflects expectations that the Federal Reserve could be forced to decrease interest rates to provide liquidity to a slowing economy.
One of the most accurate predictors of an economic recession is the inverted yield curve. Other indicators, such as Gross Domestic Product and the Leading Index of Economic Indicators are actually trailing studies, which tend to confirm recession when we're already in it. The inverted yield curve however, is usually an accurate forecast of a slowdown.
Notice the date of the above chart - that's right - September 2000. The yield curve has been inverted during most of the summer of 2000. Does this mean that in the year 2001 we are headed toward recession? We'll, we didn't say that the inverted curve is ALWAYS correct, but usually. The odd thing about the summer of 2000 is that the U.S. Government is engaged in a huge buyback of long-term bonds, which is artificially pushing yields down on the longer-term maturities. Still though - there is an inversion…
A study done by Estralla and Mishkin published in Current Issues in Economics and Finance looked at the relationship of inverted yield curves to recession. It found that the amount of the spread between the three-month bill and the ten-year bill had a correlation to the predicative ability of the inverted curve. It was found that a spread of -0.50% had an accuracy rating of 40%. A spread of -1.5% was accurate 70% of the time and a -2.4% spread was accurate 90% of the time. In September 2000, the spread was at 0.41%. In other words, the current inversion is a relatively minor one.
Steep Yield Curves
An economy that is moving from recession to growth is often characterized by long-term rates well in excess of short-term rates. In the waning days of a recession, short-term yields will remain low, but long term yields will begin to rise sharply in the expectation that the Federal Reserve will be forced to raise interest rates to fight back inflation (remember- the curve forecast is for several quarters in advance). Investors need a higher yield for purchases of the long bond, because they believe that interest rates are likely to increase very soon.
A steep curve is often found at the end of a recession, several quarters before the expansion occurs. Yields on short-term bonds remain depressed because the yield curve is predicting growth several quarters in advance. Spreads between the 3-month bill and the 10-year note in excess of 2.5% are considered "steep".
Noting the chart above, December 1992 was a period when the U.S. economy was emerging from a rather sharp depression that was caused, in part, by high energy prices from the Gulf War. The yield curve was right again. By 1994, solid economic growth was in place and the yield curve returned to normal.
