Sketchtool was used to create this image. The Treasury Yield Curve Can Predict Recessions With Reliability. This is why. This is why.
Which yield curve is associated with future recessions?
The slope of the Treasury yield curve has been shown in numerous studies to be a reliable predictor of recessions. 2 The empirical data in figure 1 displays the term-structure slope, which is assessed by the spread between the yields on ten-year and two-year US Treasury securities, as well as coloring that signifies US recessions (dated by the National Bureau of Economic Research). Since the 1970s, the yield-curve slope has grown negative before every economic downturn. 3 In other words, a “inversion” of the yield curve, in which short-maturity interest rates exceed long-maturity interest rates, is usually associated with a near-term recession.
: Ten-to-two year yield-curve spread
Previous research has used statistical models like probit specifications to estimate recession probability based on this empirical regularity. Figure 2 depicts a probit analysis that demonstrates the fitted likelihood of a recession over the next year when the explanatory variable is the ten-to-two-year yield-curve spread. With the exception of a false positive in the mid-1960s, the fitted likelihood peaks before the start of each recession.
Estimated recession probabilities, long-spread model
While the literature has discovered that this variable has predictive value, it has been less successful in determining why such an empirical link exists. Financial experts appear to believe that the slope of the yield curve contains information regarding present and predicted future monetary policy actionsi.e., the Federal Reserve’s raising or lowering of the federal funds ratewhich are linked to predictions of future business cycle outcomes. However, because the yield curve is impacted by factors other than monetary policy expectations, this is an imperfect picture. The yield curve, in instance, indicates market perceptions of various risks, which are influenced by economic outcomes. If the discrepancies between long-run and short-run values for policy expectations or risk variables represent market judgments of the likelihood of a future recession, then they will be useful in forecasting recessions to the extent that these assessments are right or self-fulfilling.
Furthermore, both the predicted interest rate path and the risk premium have numerous components. Market participants’ expectations for the future evolution of inflation and real (inflation-adjusted) interest rates impact expected rates. Similarly, bondholders’ risk reflects uncertainty about future inflation as well as the path of future real interest rates. The slopes of these multiple components of expectations and risk premia could reveal diverse information about future economic scenarios, which could help projections.
We investigate the differing effects of these channels on the estimated chance of a recession in this Chicago Fed Letter and find that they actually have diverse influences. We also provide some economic interpretations for these yield curve-to-broader macroeconomic correlations.
The yield-curve slope and recession risk
Many different metrics of the yield-curve slope, or term spread, have been studied in the literature. The difference between the yield on the ten-year Treasury note, which reflects bond investors’ long-term views, and the three-month Treasury bill rate, which is a close substitute for the federal funds rate targeted by the Federal Reserve’s policymaking body, the Federal Open Market Committee, has frequently been used in academic studies (FOMC). The difference between the ten- and two-year yields, on the other hand, is frequently used by practitioners and financial analysts. 4 Both criteria have merit, and when used in statistical models for recession predictions, they generate qualitatively identical results.
Why do these yield-curve slopes appear to be useful in predicting recessions? Remember that the interest rate on a long-term bond is influenced by the predicted path of short-term interest rates over the bond’s tenure. Views on the business cycle and monetary policy, in turn, influence the projected course. If market investors predict a downturn, they will almost certainly expect the FOMC to decrease its policy rate in the near future to provide monetary policy relief. Longer-term rates fall as the expectation of lower future rates falls, perhaps resulting in an inverted yield curve. A further explanation is that market investors may believe that the FOMC’s aggressive monetary policy tightening, which would raise current rates compared to future rates, would increase the odds of a future economic downturn. Such movements in the yield-curve slope will be associated with a higher probability of a future recession to the extent that the market’s expectation of a downturn is right.
Engstrom and Sharpe (2018)5 investigate an alternate yield-curve slope metric, the difference between the six-quarter-ahead forward rate on US Treasury securities and the present three-month Treasury bill rate, to better isolate this monetary policy channel “forward spread in the near term.”
6 They suggest that the six-quarter-ahead advance rate is more accurate than spreads based on the ten-year yield in identifying important market expectations of future monetary policy measures. This is because the long-term yield is a weighted average of forward rates over ten years, diluting the signal in shorter-term rate changes associated with business cycle variations. Engstrom and Sharpe (2018) find that the near-term forward spread crowds out other slope measures in probit models that predict U.S. recessions, and they conclude that a negative near-term spread may only predict recessions because it reflects the market’s expectation that a contracting economy will cause the Federal Reserve to lower its policy rate.
However, monetary policy expectations may not be the only link between the yield curve slope and future economic activity. Changes in the slope could be influenced by shifts in market participants’ risk attitudes, and these shifts could help predict economic downturns. We can use a dynamic term-structure model (DTSM) to break down the nominal yield y on a Treasury security of any maturity into components associated with expected inflation, expected real interest rates, and the risk premia that investors require to invest in a security that exposes them to inflation and real interest rate risks in order to study this second channel:
where $$ is the average expected path (EP) of consumer-price inflation throughout the bond’s life and $$ is the inflation-adjusted real rate’s average expected path over the same horizon. The expected path of the nominal interest rate, $$, is the total of these components. The bond’s yield additionally includes an inflation risk premium $$ and a real rate risk premium $$, which reflect compensation for the risk of future inflation and real interest rate movements, respectively. The term premium, $$, is the overall compensation that investors want in exchange for bearing interest rate risk. Finally, an error term $$ may cause the observed Treasury yield to diverge from the DTSM-implied value; because $$ is modest, we ignore it for the rest of the analysis.
We can deconstruct the slope of the yield curve into its expectations and risk-premia components using equation 1:
Fluctuations in each of these parameters may be linked to various growth potential. We investigate this issue by constructing these distinct components using an estimated DTSM and then allowing these factors to have varied affects in a probit model that estimates the likelihood of the US economy entering a recession within the next year. Benzoni and Chyruk provide more information on the analysis (2018). 7
The exact breakdown described in equations 1 and 2 is not used. We utilize slope $$ words that concentrate on near-term spreads because the predicted monetary policy explanations focus on a shorter time frame than 10 years. We utilize the difference between the model’s six-quarter-ahead inflation forecast and its projection of average inflation over the next three months for slope $$, and the difference between the model’s six-quarter-ahead and current three-month forecast for real interest rates for slope $$. Changes in risk attitudes become more obvious in the pricing of longer-term bonds for a variety of reasons. 8 We utilize the difference between the ten-year and two-year $$ and $$ terms from the DTSM model for slope $$ and slope $$. Finally, we adjust for current monetary policy by inserting the DTSM-implied estimate of the current real rate, following Harvey (1988) and Estrella and Hardouvelis (1991). 9
We discover that monetary policy loosening, whether present or predicted, is linked to a higher risk of future recession. A decrease in the spot real rate or a decrease in the near-term spread in the real projected rate path, all else being equal, increases the model’s chance of recessions. Statistics show that the impacts are statistically significant.
The predicted inflation component’s spread has little effect on model fit. As a result, it is not included in the baseline probit definition. This data supports the hypothesis that inflation expectations were relatively steady across the post-1985 sample period, even while recession risk was high. The recession signal is contained in the anticipation of future monetary policy, as assessed by changes in the slope of the predicted real-rate path.
Long-term risk premia changes provide predictive information as well.
10 A decrease in the $$ slope raises the chances of a recession. Why is this the case? During periods of low inflation, the fixed nominal cash flows from a nominal bond become more appealing, causing bond prices to rise and interest rates to fall. The risks of surprisingly low inflation have increased in recent recessions, compared to the risks of unexpectedly high inflation. 11 As a result, if investors believe the chances of a recession are increasing, the long-term inflation risk premium in Treasury bonds will decrease. Increases in the long-term $$ spread, on the other hand, are linked to an increased risk of recession. One view is that if investors believe there is a larger danger of recession, they would place a higher value on short-term assets that can be rapidly liquidated to fund consumer spending. As a result, they will want higher compensation, i.e., more money, in order to continue holding long-term securities. It’s worth noting that the direction of the $$ spread defies common wisdom: a decrease in the yield-curve slope as a result of a lower $$ spread indicates lower, not higher, recession probabilities.
Figure 3 shows the fitted probability that the US economy would undergo a recession in the coming year for the sample period 1985:Q1 to 2018:Q1. The red line depicts the recession probability calculated by Benzoni and Chyruk (2018), while the blue line depicts the fit of a probit model that adds the ten-to-two-year yield-curve spread as a single predictor of downturns (the blue line) “model (also known as a “long-spread” model). Before a recession, the projected likelihood increases in both models. The red line, on the other hand, has more prominent peaks before each of the three recessions in the sample. In addition, the red line, when compared to the blue line, downplays the likelihood of recession in the 1990s and recent years. This suggests that the model proposed by Benzoni and Chyruk (2018) performs better than the more traditional probit specification with a lone yield-curve slope predictor; in particular, a statistical test of equal predictive accuracy between the long-only model and the BenzoniChyruk model is rejected with a 1 percent $$.12 error. In either event, the two models estimate the probability of a recession to be roughly 17 percent as of the first quarter of 2018.
Conclusion
What makes an inverted yield curve such a good forecast of future recessions? The yield-curve slope is a single indicator that aggregates several diverse elements that impact the state and evolution of the economy. We present our findings in Benzoni and Chyruk (2018), which show that decomposing the yield-curve slope into its expectations and risk-premia components helps separate the mechanisms that connect Treasury rate swings with the economy’s future state.
We find that monetary policy loosening, as measured by a lower current real-interest rate or a narrowing of the predicted real-rate differential, is related with a higher likelihood of a recession in the coming year. In contrast, depending on the source of the downturn, a decrease in the slope of risk premia is related with either a larger or reduced recession probability. In recent years, a drop in the inflation risk-premium slope has been associated with a higher risk of recession, but a lower real-rate risk-premium slope has been associated with a reduced risk of recession. This indicates that not all yield-curve slope decreases are bad news for the economy, and not all steepenings are good news either. 13
Of fact, the evidence presented in this article does not prove that a yield-curve inversion causes a recession. Rather, it’s possible that the slope changes to reflect shifting economic expectations, and that these expectations are useful predictors of economic downturns.
In addition, our findings are dependent on a variety of modeling assumptions. To begin, we use a specific DTSM to parse the term-structure components’ expectations and risk premia. Second, probit models of recession probability can be specified in a variety of ways. Our findings are resilient to a number of alternative modeling options that we investigated, but not all of them. The findings presented here are based on a specific set of assumptions and are part of a larger project aimed at better understanding the relationship between the yield curve and the macroeconomy.
Why does an inverted yield curve signal a downturn?
The yield curve is one of the most important predictors of economic downturns. This usually refers to the market for borrowing money from the US government by issuing bonds and other securities with maturities ranging from weeks to 30 years.
Each of these securities has its own yield (or interest rate), which varies in inverse proportion to the security’s market value – for example, when bonds trade at high prices, their yields are low, and vice versa. The yield curve is a chart that depicts the yields of securities at each maturity date in order to see how they relate to one another.
In normal times, investors demand greater rates of return for money they lend over a longer time horizon as a compensation for higher risk. The yield curve usually slopes upward to reflect this. When it slopes down, or inverts, it indicates that investors are more pessimistic about the long future than the near term: they believe a downturn or recession is imminent.
This is because they believe the Federal Reserve, the United States’ central bank, will decrease short-term interest rates in the future to help the economy recover (as opposed to raising rates to cool down an economy that is overheating).
The link between two-year and ten-year US Treasury debt is the most closely observed. The graphic below shows the so-called spread between these two indicators, with the grey areas representing recessions that have tended to follow shortly after.
As you can see, the yields on these two securities are approaching parity, and the trend indicates that the two-year will soon have a greater yield, indicating that the curve is inverting. The big question is whether an inverted yield curve signals an impending downturn. Certainly not. Please allow me to explain why.
Is a downward-sloping yield curve a sign of impending recession?
“On the surface, a downward-sloping yield curve just indicates that investors expect rate decreases but does not explain why.” Investors may be concerned about a recession and anticipate a rate cut from the Federal Reserve. Alternatively, they could be anticipating a rate drop by the Fed in reaction to lower inflation.
What is the form of the yield curve when a recession begins?
WHAT DOES IT MEAN TO HAVE AN INVERTED CURVE? According to a 2018 paper by academics at the Federal Reserve Bank of San Francisco, the U.S. curve has inverted before each recession since 1955, with a recession following between six and 24 months. It only gave a false signal once during that time.
After an economic downturn, what happens to the yield curve?
- The yield curve is a graph that depicts the yields on similar bonds over a range of maturities.
- Short-term debt instruments with the same credit risk profile have greater yields than long-term debt instruments with the same credit risk profile, resulting in an inverted yield curve.
- An inverted yield curve is unique; it implies bond investors’ expectations for longer-term interest rates to fall, which is usually linked with recessions.
- As a proxy for the yield curve, market participants and economists utilize a variety of yield spreads.
What is a yield curve that slopes downward?
The opposite tale is told by a “inverted” or downward sloping yield curve. It hinted to the possibility of a downturn. People who believe interest rates (and consequently bond yields) will be lower in the future than they are now have a downward sloping yield curve. Central banks typically lower interest rates to promote economic growth. The theory is that if borrowing money is less expensive for investors, consumers and businesses will borrow more money and spend and/or invest it, resulting in increased economic growth. In order to combat a recession, this form of monetary stimulation is frequently used.
When does an inverted yield curve signal the start of a recession?
Every five years, the US economy experiences a recession. As a result, an inverted yield curve that forecasts recession three years in advance is similar to a stopped clock that is correct twice a day.
In other words, the median duration between the initial inversion of the yield curve and the commencement of a recession has been 18 months over the previous six decades, according to Brian Levitt, global market strategist at Invesco. Here are a few examples of why the curve isn’t very useful as a leading indicator:
- The next recession didn’t come until 1969, or 48 months after the yield curve inverted in 1965.
- In March 2001, the recession triggered by the burst of the IT boom began. The yield curve, on the other hand, had inverted 34 months earlier, in May 1998.
What is the definition of an inverted bond yield curve?
The yield curve “flattens” as the difference between short and long yields narrows. An inverted yield curve occurs when long-term yields fall below short-term yields on rare occasions.