Recession Forecast -The Yield Curve as a Leading Indicator -a Successful Record

by Ivan Smile

As an update and preface to this article, I originally wrote this on September 22, 2007 long before the current credit issues made the big business news headlines and about a month before the stock market peaked on October 31, 2007.

The lessons learned if you read further are many, but the primary message is when you get the yield curve inversion signal, the caution lights should be flashing. Although my interpretation of the Yield curve inversion was off when this article was originally penned, it is clear the signal was correctly flashing recession.

The points made in this article are valid, and it is not just the inversion but also the amplitude and duration of the inversion which is important. I would also state that it is important to combine this signal with the mosaic of other signals. Never ignore potential Economic events and their impact on growth.

The bottom line is we can add the Recession of 2008-2009 to the successful predictive calls by the Yield Curve inversion.

The following is the original article I wrote on September 22, 2007. Much can be learned by reading this article. Ignore the Yield Curve Inversion at your peril.

So, Recession or No Recession that is the question. My interpretation of the Dynamic Yield curve is @ September 22, 2007, we will not have a recession. There were many instances in the last year or so where the yield curve inverted (in 2006 Feb., Mar., Nov., Dec. & in 2007 Jan., & Feb. ) but my interpretation is that the limited duration and relatively low interest rates due to Foreign Capital inflows were among the mitigating factors which negated the Recession signal for the Yield curve. In other words the yield curve inversions sited never would have taken place if the long end yield was not pushed lower due to the demand of surplus foreign capital looking for a safe harbor here in the US.

In my never ending quest to discern good market valuation tools and market directional indicators, I am revisiting the use of the yield curve as a reliable tool to presage when a recession would likely occur for the US economy.

The bottom line for me as an investor is the yield curve is an excellent predictive tool to use, and "since 1960, a yield curve inversion (as measured by the difference between ten-year and three-month Treasury rates) has preceded every recession on record. In fact, in terms of monthly averages, the ten-year rate was at least 12 basis points below the three-month rate before every recession in that period."

As an investor I use the 3 month Tbill to compare to the long end of the yield curve (currently the 10 year US Tbond but in prior years the 30 year Tbond was used). The reason for not using the very short end Fed Funds rate for comparison is simply because it is subject to direct manipulation by the Fed to control monetary policy. In addition I factor out external noise such as demand buying of our long end by Foreigners by keeping the level of relative interest rates in mind as an offsetting factor.

Below I present 2 reference articles which support my premise that the Yield Curve is a reliable indicator if used and interpreted properly.

The first article is from the Federal Reserve Bank of New York written in October 2005 Author: Arturo Estrella (Senior Vice President in the Capital Markets Department of the Research and Statistics Group at the Federal Reserve Bank of New York).

The Q&A portion is a little tedious to read so I will try and highlight by bolding the salient points.

Reference Article #1:  The Yield Curve as a Leading Indicator

October 2005

Author: Arturo Estrella

http://www.ny.frb.org/research/capital_markets/ycfaq.html

A broad literature originating in the late 1980s documents the empirical regularity that the slope of the yield curve is a reliable predictor of future real economic activity. Today, there exists a substantial body of evidence from which various useful stylized facts have emerged. This catalogue of some of the salient findings takes the form of answers to frequently asked questions. An extensive bibliography is also included.

Note from the NY Fed: Views expressed are the author's and do not necessarily represent those of the Federal Reserve Bank of New York or the Federal Reserve System.

Questions & Answers

Q. What does the evidence say, in short?

A. The difference between long-term and short-term interest rates ("the slope of the yield curve" or "the term spread") has borne a consistent negative relationship with subsequent real economic activity in the United States, with a lead time of about four to six quarters. The measures of the yield curve most frequently employed are based on differences between interest rates on Treasury securities of contrasting maturities, for instance, ten years minus three months. The measures of real activity for which predictive power has been found include GNP and GDP growth, growth in consumption, investment and industrial production, and economic recessions as dated by the National Bureau of Economic Research (NBER). The specific accuracy of these predictions depends on the particular measures employed, as well as on the estimation and prediction periods. However, the results are generally statistically significant and compare favorably with other variables employed as leading indicators. For instance, models that predict real GDP growth or recessions tend to explain 30 percent or more of the variation in the measure of real activity. See Estrella and Hardouvelis (1991). The yield curve has predicted essentially every U.S. recession since 1950 with only one "false" signal, which preceded the credit crunch and slowdown in production in 1967. There is also evidence that the predictive relationships exist in other countries, notably Germany, Canada, and the United Kingdom. See Estrella and Mishkin (1997) and Bernard and Gerlach (1998).

Q. What maturity combinations work best?

A. When the yield curve is used to predict inflation (e.g., as in Mishkin (1990a, 1990b), interest rate maturities are matched precisely with the forecast horizons for inflation. For instance, to predict the difference between inflation expected in the next five years and inflation expected in the next year, the difference between five-year and one-year Treasury yields is used. When forecasting real activity, in contrast, the best results are obtained empirically by taking the difference between two Treasury yields whose maturities are far apart. At the long end, the clear choice seems to be a ten-year rate, which is the longest maturity available in most countries on a consistent basis over a long sample period. At the short end, there is a wider variety of choices. An overnight rate, such as the fed funds rate, is close to the extreme of the maturity spectrum. However, its usefulness as an indicator of market expectations is confounded by its fairly direct control by the Federal Reserve. A common choice currently is the two-year Treasury rate, perhaps because of the liquidity of the associated instruments. Background research in connection with Estrella and Mishkin (1998) suggested that the three-month Treasury rate, when used in combination with the ten-year Treasury rate to predict U.S. recessions, provides a reasonable combination of accuracy and robustness over long time periods. In the end, most term spreads are highly correlated and provide similar information about the real economy, so the particular choices with regard to maturity amount mainly to fine tuning and not to reversal of results. The caveat is that a benchmark that works for one spread may not work for another. For instance, the ten-year minus two-year spread may invert earlier than the ten-year minus three-month spread, which tends to be larger.

Q. Is it the level or the change in the spread that matters?

A. With many leading economic indicators, either individual variables or indices, analysts focus on the change or growth rate in the variable as a forecaster of future real economic conditions. In contrast, it is the level of the term spread - not the change - that helps forecast both recessions and changes in real economic activity. For recessions, it is clearly the level that matters. In a probit model of the probability of recession, a given change in the spread can have a very different impact, depending on the initial level of the spread. When the curve is very steep, say the spread is above 300 basis points, a change of 50 basis points in the spread hardly changes the probability of recession. However, if the spread starts out at 50 basis points, a decrease of that magnitude may raise the implied probability by 10 percentage points or more. Theoretical explanations of these empirical results are not easily formulated. A suggestive heuristic argument is that the term spread, being a difference between interest rates of different maturities, incorporates an element of expected changes in rates and is thus indicative of future changes in real activity. In 1996, the Conference Board added the yield curve spread to its index of leading indicators, focusing on monthly changes in the spread. Note, however, that it announced in June 2005 that it would adjust its procedures so as to focus on the level of the spread and not on the change.

Q. Does it matter if changes are driven by the short or the long end?

A. The best forecast of future real activity is provided by the level of the term spread, not the change in the spread, nor even the source of the change in the spread. Thus, if a low or negative value of the spread is reached via an increase in the short-term rate or a decrease in the long-term rate, it is only the low level that matters. In the six months preceding the trough of each yield curve inversion in the United States since 1960, we see a decline in the ten-year Treasury rate in two of seven cases (before the 1990-1991 and 2001 recessions) and an increase in the other cases. The direction of the change in the ten-year rate at the time of the signal does not appear to be indicative of the strength or duration of the subsequent recession. It is clear, however, that each recessionary episode is preceded (with varying lead times) by a substantial increase in the short-term rate.

Q. Is an inversion required for a signal?

A. Although economic theory suggests that the yield curve should help forecast real output, no theory establishes a clear connection specifically between yield curve inversions and recessions. However, since 1960, a yield curve inversion (as measured by the difference between ten-year and three-month Treasury rates) has preceded every recession on record. In fact, in terms of monthly averages, the ten-year rate was at least 12 basis points below the three-month rate before every recession in that period. In contrast, very low positive levels of the spread have been observed without a subsequent recession. Specifically, there were two episodes in the 1990s in which the term spread attained very low positive levels (42 and 12 basis points respectively), but did not invert. In both of those cases, economic activity continued unabated after the troughs or low points for the spread. Thus, using inversion as a benchmark, there were no "false positives" during the period. While inversions and recessions may not be inevitably connected by theory, they correspond to extreme values of the term spread and output growth, respectively, which are in fact theoretically linked.

Q. Does the signal have to be persistent?

A. Daily or even intraday changes in the term spread can be substantial. For example, for the spread between ten-year and 3-month rates, one-day changes of over 25 basis points occur about 2½ percent of the time. In some cases, these changes may be driven by market expectations of economic fundamentals and consequently may be persistent. In many instances, though, high-frequency changes in the spread may result from temporary demand or supply imbalances in the markets for Treasury securities, which may be quickly reversed and thus may not be truly reflective of changes in expectations about real economic conditions. One way to distinguish between perceived changes in fundamentals and temporary market phenomena is to trace the persistence of yield curve signals. A signal that lasts only one day may be dismissed, but a signal that persists for a month or more should be looked at carefully. Statistically, these distinctions may be captured by using data averaged over one month or more, which is quite common in the literature, or by including lagged effects in the model, as in Chauvet and Potter (2005).

See the linked article for the complete Q&A.

The second reference which supports the premise of my article is entitled: Yield Curve Inversion - Necessary But Not Sufficient Recession Condition by Paul Kasriel.

Note: as the first reference article stated, the results you get depend on the input used specifically, the distinction here is the short end used for comparison for this reference article was the fed funds rate not the 3 month Tbill which led to a slightly different conclusion as indicated by the title of this second reference article.

Reference Article #2:

Yield Curve Inversion Necessary But Not Sufficient Recession Condition

by Paul Kasriel

December 21, 2005

http://www.safehaven.com/article-4321.htm

As shown in the chart below, each of the past six recessions (shaded areas) was preceded by an inversion in the spread between the Treasury 10-year yield and the fed funds rate. But there were two other instances of inversion - 1966:Q2 through 1967:1 and 1998:Q3 through 1998:Q4 - immediately after which no recession occurred. It would appear, then, that an inverted yield curve is more of a necessary condition for a recession to occur, but not a sufficient condition. That is, if the spread goes from +25 basis points and to -25 basis points, a recession is not automatically triggered. Rather, whether an inversion results in a recession would seem to depend on the magnitude of the inversion and, to a lesser extent, the duration of it. Recession-signaling aside, the yield curve remains a reliable leading indicator of economic activity. Although the spread going from +25 basis points to -25 basis points might not result in a recession, it does indicate that monetary policy has become more restrictive. For a description of the theoretical underpinnings of why the yield spread is a leading indicator, see

http://www.northerntrust.com/library/econ_research/weekly/us/pc070805.pdf.

For some descriptive data on the past eight spread inversions, see the table below.