Monetary Policy

Yield Curve and Predicted GDP Growth, July 2013

Covering June 15, 2013July 19, 2013 by Joseph G. Haubrich and Margaret Jacobson

Highlights
July Three-month Treasury bill rate (percent) Ten-year Treasury bond rate (percent) Yield curve slope (basis points) Prediction for GDP growth (percent) Probability of recession in one year (percent) 0.03 2.54 251 0.9 2.6 June 0.05 2.20 215 0.4 4.4 May 0.04 1,93 189 0.3 6.1

Overview of the Latest Yield Curve Figures Over the past month, the yield curve steepened sharply as long rates surged and short rates ticked down, increasing the slope even more than last month. The three-month Treasury bill dropped to 0.03 percent (for the week ending July 19), down from Junes 0.05 percent and from Mays 0.04 percent. The ten-year rate moved to 2.54 percent, a third of a percent above Junes 2.20 percent, and more than half a percent above Mays 1.93 percent. The slope increased to 251 basis point, up from Junes 215 basis points, and well above the May level of 189 basis points. The steeper slope had a small but noticeable impact on projected future growth. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 0.9 percent rate over the next year, up a bit from Junes 0.4 percent and triple Mays 0.3 percent. The strong influence of the recent recession is still leading towards relatively low growth rates. Although the time horizons do not match exactly, the forecast comes in on the more pessimistic side of other predictions but like them, it does show moderate growth for the year. 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 July is 2.58 percent, down from Junes already low 4.35 percent and Mays 6.1 percent. So although our approach is somewhat pessimistic regarding the level of growth over the next year, it is quite optimistic about the recovery continuing.

Sources: Board of Governors of the Federal Reserve System; authors calculations.

Yield Curve Predicted GDP Growth

Percent 4 2 0 -2 -4 -6 2002 Ten-year minus three-month yield spread GDP growth (year-over-year change) Predicted GDP growth

2004

2006

2008

2010

2012

2014

Sources: Bureau of Economic Analysis, Board of Governors of the Federal Reserve System, authors calculations.

Federal Reserve Bank of Cleveland, Economic Trends | August 2013

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Recession Probability from Yield Curve

Percent probability, as predicted by a probit model 100 90 80 70 60 50 40 30 20 10 0 1960 1966 1972 1978 1984 1990 1996 2002 2008 2014 Forecast Probability of recession

The Yield Curve as a Predictor of Economic Growth The slope of the yield curvethe difference between the yields on short- and long-term maturity bondshas 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.

Note: Shaded bars indicate recessions. Sources: Bureau of Economic Analysis, Board of Governors of the Federal Reserve System, authors calculations.

Yield Curve Spread and Real GDP Growth

Percent 10 8 6 4 2 0 -2 -4 -6 1953 1960 1967 1974 1981 1988 1995 2002 2009 10-year minus three-month yield spread GDP growth (year-over-year change)

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 materi-

Note: Shaded bars indicate recessions. Source: Bureau of Economic Analysis, Board of Governors of the Federal Reserve System.

Federal Reserve Bank of Cleveland, Economic Trends | August 2013

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Yield Spread and Lagged Real GDP Growth

Percent 10 8 6 4 2 0 -2 -4 -6 1953 1960 1967 1974 1981 1988 1995 2002 2009
Ten-year minus three-month yield spread

One-year lag of GDP growth (year-over-year change)

ally 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.
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 Yorks estimate fo recession, visit http://www.newyorkfed.org/research/capital_markets/ycfaq.html.

Note: Shaded bars indicate recessions. Sources: Bureau of Economic Analysis, Board of Governors of the Federal Reserve System.

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