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The Predictive Power of the Yield Curve

Here’s an interesting report from the Globe & Mail on the probability of recession, as predicted by the yield curve. See this story.

The yield curve is a line chart that connects interest rates for range of securities that all have equal risk, but different maturity dates. Below is a chart of Canada’s government bond yield curve.

The Globe writes that inverted yield curves (short rates above long rates) “have preceded each of the last seven recessions.”

The Cleveland Federal Reserve says: “The rule of thumb is that an inverted yield curve indicates a recession in about a year.”

Below is a snapshot of today’s curve. You’ll notice that it is upward sloping and definitely not inverted. For those who put weight in this indicator, its current shape portends economic growth to come—which in turn suggests some degree of higher rates down the road.

Yield-Curve

Of course, it pays to remember that no indicator is foolproof (the yield curve has generated false signals in the past). Moreover, as we saw in April and May, bond market sentiment can change on a dime.