The Yield Curve as an Economic Forecasting Tool
By Bill Addiss
Shrewd investors and speculators are wise to look at the Treasury Yield curve as an indicator of where the U.S. economy is heading. Historically, it has been an incredibly accurate barometer to forecasting the economy. In fact, starting in the 1960’s the yield curve has accurately predicted the last 7 recessions the US economy has endured.
Note: The yield curve is the rate that the US Treasuries offer investors to invest in various maturity instruments they offer, (Bills, Notes Bonds, ranging from maturities from 1 month to 30 years). It indicates the interest rates which the US government must pay to borrow money. When the short-term interest rates are higher than long term rates, that is called an “inversion”. This is not the traditional or normal environment.
Traditionally, we should expect long term rates to be higher than short term rates: meaning the longer tie you up your money, the more you should earn. When longer rates are higher than shorter term rates, that is called a “normal”, or “positive” yield curve. When the yield curve inverts, that is the marketplace predicting a recession. Each of the last 7 recessions were accurately predicted when the yield curve inverted within approximately a year of the economy entering that recession. Most recently, the yield curve inverted in August 2006, a bit more than a year before the recession started in late 2007.
The constantly changing shape and curve of the yield curve acts as a predictor of the economy. Looking at the different shapes, we see:
Yield Curve Example 1: Positive or “Normal” Yield Curve
A normal or “positive” yield curve is forecasting a strong economy. It is forecasting positive economic growth, rising interest rates and increasing inflationary pressures.
Yield Curve Example 2: Inverted Yield Curve
As described, an inverted curve is predicting an economic downturn (recession), resulting in diminishing economic growth, lowering interest rates and deflationary pressure. The past 7 recessions have all been accurately predated by an inversion of the yield curve
Yield Curve Example 3: “Flat” Yield Curve
When the yield curve is relatively “Flat”, meaning no substantial change in interest rates across the spectrum of maturities, that is a forecast for a lackluster or stagnant economy
As we enter the 4th quarter of 2017, the yield curve is extremely flat. The differential between 1-month interest rates and 30-year rates is less than 2%. Historically, this is extremely low, and the curve has flattened considerably this year. Yet, the Dow Jones Industrial Average has hit 40 historic highs this year. Needless to say, we are now getting very different indicators from the bond and equity markets. Time will tell if the accuracy of the bond market will prove itself once again.
About the Author
Mr. Addiss develops and facilitates educational programs for a variety of major financial institutions, government agencies and foreign governments.