The Yield Curve as a Predictor of the Business Cycle

One of the most accurate forecasting measures of economic activity, and component of the Conference Board’s index of leading economic indicators, is the slope of the yield curve. The yield curve is simply the graphical relationship between the yield on U.S. Treasury securities and their maturities.

When economists want to know if the economy is headed into recession, there is no better place to look than at the interest rate spread. That is, the

EXHIBIT 2.5 Chicago Fed National Activity Index

Source: Bloomberg difference between longer-dated maturity Treasury fixed-income instruments like the benchmark 10-year Treasury note, and one of the short-term measures like the Fed funds rate, the 3-month Treasury bill, or the 2-year Treasury note. The most common measure on the Street is the Fed-funds, 10-year Treasury note spread. How does this work?

For example, if the federal funds rate is 1.00 percent and the 10-year Treasury is yielding 3.15 percent, the spread is 2.15 percent, or 215 basis points (a basis point is one-hundredth of a percent). The interest-rate spread embodies fixed-income traders’ expectations about the economy.

Longer-term rates are usually higher than shorter-term rates, because more things can affect the value of the bond in 10 years than in overnight, 3 months, or 2 years, and lenders require greater rewards for undertaking these greater risks. Thus, under “normal” economically favorable conditions, interest-rate spreads are positive, and the shape of the yield curve is gently convex—rising somewhat more steeply at the short end and leveling off a bit at the longer maturities.

Steep curves—very large spreads—may temporarily be the result of current economic weakness. The Federal Reserve seeks to counter such weakness byreduc- ing the overnight rate, thus lowering borrowing costs and encouraging business investment and consumer spending on interest rate-sensitive goods and services like housing and automobiles. This move stimulates the economy but can spark inflationary fears among the fixed-income community. Inflation erodes the value of future interest and principal payments. In anticipation, fixed-income investors sell off longer-term (more inflation-sensitive) bonds, depressing their prices and raising their yields. This, combined with the Fed’s lowering of the short-term rate, steepens the yield curve. Conversely, when the economy seems to be running too hot, the Fed may seek to forestall a rise in inflation by raising its target overnight rate, discouraging spending and so slowing growth. The result is a flatter yield curve (smaller spreads).

At times, the curve may become “inverted,” with short-term rates higher than long-term rates and spreads below zero. This situation is generally associated with economic downturns, and if sustained in recessions, as illustrated in Exhibit 2.6.

Why does an inverted yield curve predict recessions? There is no definitive answer. One possible explanation may be that an inverted curve may result from the Fed’s overdoing it—raising rates so high they not only cool but stifle growth (as well as any fears of inflation). What is clear is that expectations of weak economic conditions may encourage expectations of lower interest rates. This, in turn, leads to more purchases of longer-term bonds, pushing up their prices and lowering their yields. The result is an inverted curve.

While there has never been a recession without an inverted yield curve, there have been occasions where the yield curve has been inverted, with no associated economic downturn. In other words, an inverted yield has engendered a false recession signal. While it is not failsafe, the yield curve is one of the most respected measures of the economic cycle that investors have today.

EXHIBIT 2.6 Yield Curve

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