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|  | JANUARY 9, 2006
By David Wyss Does The Yield Curve Matter?Despite arguments to the contrary, S&P still has respect for its historical performance as a predictor of recessionOver the last 35 years, the yield curve -- the difference between long-term and short-term interest rates -- has been one of the best leading indicators of recession. The yield curve has inverted (long-term rates dropping below short-term) before every recession since the 1969-70 downturn, and has given no false signals. All the current economic data still show a strong U.S. economy, although there are signs of slowdown in both manufacturing and housing. The recent inversion of the yield curve, however, has created worries about recession. The logic for why the yield curve should be able to forecast recessions is based on the infallibility of financial markets. The long-term interest rate should be equal to the average expected short-term interest rate. Normally, there is a risk/liquidity premium added, which makes long-term rates average more than short-term (145 basis points between the 10-year and 3-month from 1960 through 2005). In periods when rates are stable, such as the late 1990s, the premium may narrow, while in periods of high volatility, such as the late 1970s, it may widen. But when the spread becomes negative, it signals that the market expects a downturn, which would force the Fed to cut rates. INCONSISTENT LEAD TIMES. The total yield curve (10-year vs. 3-month interest rates) is the best predictor of recession, with no false calls since 1970. The theory suggests that the spread between the longest- to shortest-term available securities should provide the best indicator. I have also eliminated very short-term inversions by looking at monthly averages rather than daily data. Before 1969, the yield curve was largely unrelated to the economy. Long-term rates remained above short-term rates from 1954 through 1966, despite three recessions. The yield curve inverted twice in the late 1960s, but no recessions followed. Lead times have been inconsistent, even since 1970. Inversion has occurred from 5 to 13 months before the beginning of each recession. The yield curve returns to being positively sloped before the end of the recession, leading the upturn by 3 to 15 months. Since the average recession has lasted only 10 months during the postwar period, the lead has been of little use for forecasting recoveries. The yield curve actually returned to being positively sloped two months before the 2001 recession even began. The recent inversion has been between the 10-year and 2-year yields. This portion of the yield curve has been less useful as a signal, giving two false signals, in 1998 and 1982 (although the latter inversion was during a recession). The 1998 inversion was during the Asian currency crisis and the Long-Term Capital Management rescue, and may have been an artifact of the crisis. However, it was still a false signal. GLOBAL FACTOR. Recent academic and Federal Reserve reports find little statistical predictive power of the yield curve when other variables are included. The level of rates does have predictive power, but the term spread has little additional power once inflation and other variables are included (see "What does the Yield Curve Tell us about GDP Growth?" by Andrew Ang, Monika Piazzesi, and Min Wei, February, 2003, presented at the Finance & Macroeconomics conference at the Stanford Institute for Economic Policy Research). Departing Fed Chairman Alan Greenspan has argued that the yield curve doesn't mean what it did in the past, because bond markets have become global. Yields may thus be telling us what's expected to happen overseas, rather than what's expected to happen in the U.S. Since it seems clear that huge inflows from abroad are keeping bond yields low, the argument is logical. However, we still have a certain respect for the historical performance of the yield-curve indicator, and hope that the Fed doesn't test inversion too far. For the moment (Jan. 4), the 10-year note yield (4.37%) remains safely above the 3-month bill (4.07%), although it is about even with the 2-year yield (4.34%). Another two rate hikes by the Fed, however, could invert this curve as well.
Source: Federal Reserve  Wyss is chief economist for Standard & Poor's
BW MALL
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