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The Yield Curve as an Economic Forecasting Tool

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Bill Addiss
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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.

Access Free Financial EducationTraditionally, 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.

Understanding the yield curve

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.

Using the yield curve to predict a coming recession.

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.

What is the yield curve?

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.

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.