Yield-Curve Recession Indicator Flashes Yellow
By Caroline Baum
Sept. 5 (Bloomberg) -- Unless the shape of the Treasury yield curve normalizes in the next few months, going from its current negative to a more normal positive slope, the U.S. could be headed for a recession late next year.
That's the implication of a new paper by economists Arturo Estrella and Mary R. Trubin of the Federal Reserve Bank of New York.
Estrella has produced a significant body of research on the yield curve, or spread between a short- and long-term Treasury rate, as a predictor of recessions. One of his earlier co- authors, Columbia Business School professor Frederic Mishkin, will be sworn in today as a governor of the Federal Reserve Board.
In ``The Yield Curve as a Leading Indicator: Some Practical Issues,'' which appears in the July/August issue of the New York Fed's ``Current Issues in Economics and Finance,'' Estrella and Trubin try to quantify yield-curve signals and provide ``practical guidelines'' -- rarely a priority in econometric research -- on interpreting the spread in real time.
For ``maximum accuracy and predictive power,'' the authors use the average monthly spread between the Treasury 10-year constant maturity rate and the secondary market three-month Treasury bill rate expressed on a bond equivalent basis. ``All six recessions since 1968 were preceded by at least three negative monthly average observations in the 12 months before the start of the recession,'' they wrote.
One Down
August was the first time the monthly average on their preferred spread was negative. There is no indication from speeches, minutes or insider rumblings that the Fed is even entertaining the idea of lowering the federal funds rate, which would be anticipated in bill rates. The options being considered right now are to do nothing or raise rates to combat inflation.
Is there anything the Fed can do to un-invert the curve and avert such an outcome?
``The negatives tend to come in bunches,'' Estrella said in a phone interview last week, referring to months when the curve was inverted.
Things can change quickly. We watched former Fed chief Alan Greenspan turn on a dime from November to December 2000 when he learned from his ``sources'' (CEOs of big technology companies) that their order books had hit a wall.
Unless short-term rates get a whiff of easing prospects or long-term rates reverse their downward trend, the curve could remain inverted for the next couple of months. That would be an inauspicious signal for 12 months hence, according to the economists' research.
Intelligent Design
For some folks, the yield curve is just another form of voodoo economics.
``The fact that something, at some time, precedes something else, sometime in the future, does not mean rainy days actually predict sunny days,'' Wachovia chief economist John Silvia wrote in an Aug. 31 note to clients.
In a companion piece on the same day, Silvia called those of us who believe in the curve ``intellectually inert.''
That was enough of an insult and a challenge to inspire me to respond. Having been schooled in the yield curve by my late friend, Bob Laurent, who did the early analytical work on the spread as an economist at the Chicago Fed, I am comfortable singing its virtues and explaining its seemingly mysterious workings.
Contrary to Silvia's assertions, the spread is not a faith- based indicator. It makes perfect intuitive sense.
The inverted curve can be viewed as a reflection of monetary policy (the Fed raises short rates, slowing growth and reducing inflationary pressure and long-term rates) or investor expectations (of lower short rates), according to Estrella.
Laurent saw a steep/inverted yield curve as an incentive/ disincentive for money creation.
Strength in Numbers
The fact that the various explanations are ``mutually compatible'' suggests that ``the relationships between the yield curve and recessions are likely to be very robust indeed,'' the New York Fed economists wrote in their paper.
The simplicity of the yield curve derives from the fact that it is the expression of the interaction between two rates: one that is artificially pegged by the central bank and one that is set in the marketplace. The market rate acts as a check and balance on what the central bank is doing and reflects the stance of policy.
The Fed has been raising short-term rates, reducing the amount of credit it supplies to the banking system. Long-term rates have been falling.
If there were no central bank rate, we wouldn't know if long rates were falling because of excess supply or reduced demand. Because there is a bank pegging an overnight rate, we know that long rates aren't falling because of excess credit supply. They're falling because of weaker demand for credit. The decline, in other words, is an effect. It's not a cause of increased stimulus, as those who look at long rates in isolation seem to think.
They Doth Protest
This cycle has produced an unusually loud chorus of yield curve deniers because the flattening and eventual inversion occurred with interest rates at such low levels.
Those who protest claim that long rates are low, that the yield curve has predictive powers only when it inverts at higher yields (they never specify what the threshold is), might be interested to learn that the ``performance of the yield curve as an indicator does not depend on the movements of the long-term rate,'' according to the authors.
When Mishkin takes his seat on the Board of Governors this week, no doubt he will be an ally of Fed Chairman Ben Bernanke on the move toward implementing a formal inflation target. Let's hope he offers his insights on the yield curve as well.
(Caroline Baum, author of ``Just What I Said,'' is a columnist for Bloomberg News. The opinions expressed are her own.)
To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net .
Last Updated: September 5, 2006 00:23 EDT
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