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.

  1. That is a great piece. I think you may also want to explain what exactly yield means in bond market. Why the bond prices goes down while the yield goes up as opposed to stock market. Basically Bond is a tool to gather liquidity for businesses. It promises to pay a fixed amount of interest. If some one wants to sell his/her papers before its maturity he/she may get more or less money for it. Although, the amount of interest payable, remains the same. Hence, lower the price, higher the yield. Higher yield means there is less demand – that in turn leads to a believe that the investors are looking at other opportunities. But the variabilities in this assumption are high. The samples are so much apart that it makes it very difficult to calculate the distribution.

  2. It is so hard to for someone like me who as never bought a house to know what is good or not in mortage rates. I’m also affraid that the lowners will take advantage of my lack of knowledge.

  3. Hi William,
    If you’re well suited to the risks of a variable then yes, a variable mortgage (or at least a hybrid) may be a good solution.
    Your mortgage advisor should be able to make a good recommendation by doing a profile on you and an amortization analysis. If you don’t have an advisor, here is a mortgage planner directory, or feel free to contact us if we can help.
    Cheers,
    Rob

  4. Jim,
    Perhaps Emilie doesnt trust her broker, or is looking to verify what her broker is saying, or is looking for an honest broker, etc.
    Emilie, there are tons of great articles on this site that IMHO not biased towards anything other than the facts. There is lots on this site for novices and the more experienced.
    Good luck with your rate hunting..

  5. With short rates already near zero, it would be hard for the yield curve to invert. That wasn’t the case prior to past recessions. This rule of thumb is meaningless in the current rate environment.

  6. Paul,
    Perhaps Emilie is a mortgage broker, looking for clients with the concerns you describe? :)
    WJK,
    absolutely! Can we get a comment here rob?
    Thanks

  7. Hi WJK & Blair,
    Thanks for the comments.
    The slope of the yield curve has long been viewed as a reliable indicator of economic direction. At the moment, the curve is still somewhat steep, indicating that a recovery should eventually be in store. The Federal Reserve, for example, says the curve suggests just a 12.4% probability of the U.S. economy stumbling back into recession.
    Of course, there is never a guarantee the curve will be predictive in a given environment. Look at how poorly it performed in Japan during its last three recessions. In addition, some say the Fed’s zero interest rate policy has lessened the curve’s reliability.
    In Canada, we seem to be very early in a recovery. Some would even say we’re dragging along the bottom of an existing trough in the cycle. So, by definition, it’s going to be difficult to invert the curve anytime soon. Then again, some feel it doesn’t need to be inverted. A flat curve could imply the same outcome.
    For now, we still have a positive slope to short and long rates, so take that for what you will! Personally speaking, I like to put my money on the bets that the $34 trillion dollar bond market is making. But that’s just me. ;-)
    Cheers,
    Rob

  8. Rob – what do you mean by the Bond Market. According to another article on this great website – the Bond Market is saying that current fixed rates are over priced and leading to massive profits for banks. Is this what you mean? Rates in general are too high?

  9. A good piece. And I agree with Rob M.s comment about trusting in the decisions of the $34T bond market.
    At the same time, let’s remember this is the same bond market that didn’t forsee the 1998 Russian default, or the recent situation in Greece.
    For myself, I’m very cautious in placing too much trust in these types of historic based indicators which indicate no impending recession, because our current economic health (relative to 18 months ago) derives substantially from the staggering level of sovereign debt and stimulus pumped into the system.
    It sort of like giving a 35 yr old sprinter a big dose of cocaine, and then comparing his 100 metre time to those he had when he was 25. What happens when you take away the cocaine?
    (my apologies for the clumsy analogy, but I think that my message is clear)

  10. “(my apologies for the clumsy analogy, but I think that my message is clear)”
    It certainly left an impression!
    Anyway, FWIW the yield curve is considered predictive because banks do a lot of business by borrowing money at relatively low interest rates on the short end of the curve to fund loans on the long end at higher rates. So, they make their money on the spread between the two rates.
    So if the yield curve inverts or flattens, it does great damage to the business model of banks and as the banks go, so goes funding for the economy in general.
    The joke I always heard was that an inverted yield curve predicted 7 out of the last 5 recessions. :)

  11. Just to share: Someone said – may be wrong. Inverted Yield curve has missed to predict 5 out of 11 last recored recessions. I would not put all my faith on that only.

  12. I think your data is wrong Sudip because the yield curve has forecast all of the last seven modern-day recessions.

  13. Dear Jim,
    It is easy to predict after the event has taken place. Now the yield curve says that we should go out of the problem. But look around – there are lot of people even saying that there is a fair possibility of a depression. It was very clear in the latest G2 meeting. You can e-mail me if you want some detailed informations on this. I shall be happy to do that.

  14. Hi William,
    Thanks for the thoughtful feedback.
    My reference was to the market for government bonds. Your point pertains to the spread between bond yields and fixed mortgage rates, which is a somewhat different topic.
    The yield curve doesn’t really provide an indication of rates being too high or too low. It’s more of a statement on where the bond market sees rates, inflation, and the economy down the road.
    Cheers,
    Rob

  15. MPatel, increased employment does not preclude an economic downturn (or even a depression).
    http://en.wikipedia.org/wiki/File:US_Employment_Graph_-_1920_to_1940.svg
    The question is why employment is increasing, and whether these are true, sustainable, jobs. The easy analysis is that new jobs means no depression (or perhaps that new jobs come only from stimulus and therefore mean nothing).
    I would agree that new jobs is certainly much more positive than lost jobs.
    However my concern is that we are seeing some wildly oscillating figures (GDP from minus 5% to plus 5% in a short time, employment plummets and then bounces back). Joined with the timing of unprecedented sovereign debt spending, I have my doubts about the positive message of these recent jobs increases. But I hope I am wrong.

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