Can the yield curve predict the future of the economy?
The short answer to the title question is yes. The long answer ends with a resounding maybe. If economics were simple, Ben Stein wouldn’t be a nerd’s paragon of mathematical virtue, a former game show host and this guy:
The yield curve is a representation of interest rates of like-kind debt investments over varying maturity dates. Connect the dots between the shortest-term facilities and the increasingly longer-term investments, label the x-axis with units of time and the y-axis with interest rates and voila! A yield curve is born.
The following are definitions of the four primary shapes of yield curves:
Normal yield curve
The normal yield curve is a positively (upward) sloping series of data points. As maturities lengthen, interest rates increase. The incremental increases begin to flatten out after the initial segment of the curve in the early stages of the maturity profile, with the differences virtually insignificant by the end of the curve.
When the curve holds for a significant period of time, the economy is generally stable and growing at a sustainable pace.
Steepening yield curve
A steepening yield curve looks like a normal yield curve, except the gap between short and long-term rates is extraordinarily wide.
This type of curve typically occurs early in post-recessionary environments when future growth, along with the potential for increasing interest rates, is on the horizon.
Flattening yield curve
A flattening yield curve represents narrowing differences between short, intermediate and long-term maturities.
This stage generally represents a transitional phase in the economic landscape, with the economy poised to head one direction or another.
Inverted yield curve
An inverted yield curve is a relatively rare scenario whereby short-term interest rates are actually higher than long-term rates.
Intuitively, it doesn’t make sense, as investors should always require more return to lock their money up for longer periods of time. It happens when substantial investment dollars flood into longer-term securities, which causes their yields to decrease. Investors avoid stocks and prefer long-term securities when they have concern about the short-term direction of the economy.
As long-term rates decline, they sometimes drop below short-term rates, inverting the curve.
The Yield Curve as a Predictive Tool
Varying factors contribute to the rise and fall of interest rates, both on the short and long ends of the spectrum. While short and long-term rates frequently shift together in tandem, they occasionally move in opposing directions simultaneously. In other words, short-term rates can rise at the same time long-term rates fall, and vice-versa. Given that interest rates are manipulated as a matter of monetary policy, the question becomes this: can the shape of the curve serve as a predictor of future economic activity?
An answer can be found in key economic data within the following highlighted periods of recent U.S. history: 1977-1983, 1989-1992, 1999-2003, and 2005 to 2008.
1977-1983
During this period, the yield curve went from normal in March of 1977 to inverted in November of 1978. It remained negatively sloped until May, 1980, a full nineteen months later.
The era was punctuated by an unprecedented rise in short-term interest rates. The prime rate, which moves with concert with the Federal Reserve’s changes to the Fed Funds rate, exploded from 6.25% to 21.5% in the span of 3 1/2 years. While real GDP growth remained strong throughout the first quarter of 1979 (averaging over 6%), it plunged thereafter, turning negative for four consecutive quarters in 1980.
After a tepid recovery, the economy double-dipped into a second recession in 1982. The term stagflation was coined, as unlike a garden-variety recession, inflation surged at the same time as growth declined. A sustainable recovery did not occur until the second half of 1983.
1989-1992
In the era of the S&L crisis, the yield curve tipped into the negative in early 1989 and remained flat or inverted for approximately 18 months.
At the time the curve tilted, real GDP was still growing at a solid 4.1% annualized rate. However, the economy lost steam as the year progressed and throughout the next, before posting negative growth for three quarters in 1991. The economy rebounded in 1992.
1999-2003
During this short period of time, the economy was hit with two staggering body blows: the exploding dot-com bubble and the 9/11 terrorist attacks.
Although the stock market bubble was fueled by frenzied speculation, the precursor to the upcoming recession was the flattening and subsequent inversion of the yield curve, starting in 1997. GDP growth stayed at normal levels until the fourth quarter of 2000, when it slowed dramatically. Growth became anemic in 2001, slipping into recession, and did not normalize until the end of 2003.
2005 to the Great Recession
Although the economy recovered from the early 2000s recession and the housing market exploded, GDP growth did not reach the same levels it had achieved during the 1990s.
After normalizing and eventually becoming steep, the yield curve flattened in 2005 before inverting in February, 2006. It vacillated between flat and inverted until the start of the Great Recession in mid-2007. The economy slowed through the end of the year and the first six months of 2008 before suffering negative growth for six consecutive quarters, the worst recession of the post-war era.
The Great Recession was declared officially over by the end of 2009, with the economy growing modestly thereafter.
Yields curves can be predictive
A normal yield curve is indicative of economic health and balanced growth. By itself, however, it does not take on predictive qualities. A flat yield curve is usually a pivot point toward impending change, but could go either direction.
A steep yield curve has historically served as an indication of strong current and/or upcoming growth. The curve steepened in the early to mid 1980’s and early to mid 1990’s, just prior to strong growth. The inverted yield curve led to all four recessionary periods cited, with a lead time of two years or less.
Therefore, the steep yield curve and the inverted yield curve appear to be the most predictive of all the shapes describe above.
Where are we now?
As mentioned above, a flattening yield curve represents a transition. Although tax cuts artificially spurred growth in 2018, the effects appear to be wearing off. As the spread between short and long rates diminishes, so does growth. Indeed, the Federal Reserve Bank of St. Louis is forecasting growth of 2.4% for 2019, in line with the average of the post-Great Recession period.
If it tips into inversion, head for your local cave and hunker down. The next recession could be another doozy.
Follow us on Facebook!
