Yield Curves

The slope of the yield curve is a good indicator of future economic activity. Discuss.

The yield curve shows us the interest rate of bonds maturing at different dates. We might generally expect – in normal times – that the yield curve would be upward sloping, which would imply that short term yields are lower than long-term yields. This would reflect the fact that investors expect interest rates to be higher in the future which would occur if they expect monetary policy to be tight, in order to fight inflationary pressures caused by an expanding economy. Hence we might think that an upward sloping yield curve is a positive reflection on the future of the economy, as investors believe that it will be overheating and will require contractionary monetary policy. However this analysis is only true if we focus on the long end of the yield curve: that long-term interest rates will be fairly high. It might be the case that we have an upward sloping yield curve because the current short term yield is low (and the long-term yield is at an average level); this will obviously imply that expectations are such that future activity will improve, but may not be particularly reassuring about the magnitude of such activity. However Haldane and Read find that the predictive power of the yield curve is independent of whether the gradient is determine from the short or long end.

A downward sloping yield curve (yield inversion) might imply that investors expect future yields to be lower than they currently are. This might occur if they expect that the economy will deteriorate in the future, and so require expansionary monetary policy to stimulate, which would lower interest rates. However, this is contrary to what would happen if fiscal expansionary policy is expected, because this is likely to be financed (at least in most of the West) by a budget deficit, requiring the issuing of bonds by the government which would lower the bond price (greater supply) and hence increase yields. This contradiction might reflect the greater importance which is attached to monetary policy over fiscal policy. Estrella and Trubin find that a yield curve inversion occurred before each of the 6 recessions preceding 2006.

Thus far we have discussed the relationship between yields and (expected) monetary policy; Estrella and Mishkin use a probit econometric model, with the yield spread as their explanatory variable, to estimate the probability of a recession occurring. A negative spread (i.e. negatively sloped yield) would reflect a higher probability of recession, because it means expectations are such that investors believe future yields will be lower, reflecting more lax monetary policy, and also the fewer opportunities to invest elsewhere (if the economy is in a poor shape then asset prices will be low, and there will be few investable projects, so overall interest rates will be low). They find that the yield curve is a much better predictor than other economic indicators, such as the stock market, at predicting recession in future periods, most accurately in 4-6 quarters ahead. The yield curve will be more successful at predicting recessions which were caused by monetary policy, which makes sense given the close relationship between monetary policy and the gradient of the yield curve.

Haldane and Read find evidence of the yield curve responses being dampened with inflation targeting in the UK in 1992, consistent with greater transparency and credibility of the central bank. Transparency dampens the yield curve volatility at the short-end whilst credibility dampens at the long end. This highlights that shifts in the yield curve do not always reflect market fundamentals, but a change in institutions.

Whilst the evidence suggests that the yield curve is quite a good predictor of future economic activity there are some caveats. The fundamental one being that changes in the yield curve may reflect other factors, and not solely economic fundamentals. For example a cultural shift in attitudes to risk, may mean that investors attach a greater risk premium to the future, not necessarily because they expect the economy to be in a bad state, but because they cannot accurately forecast for such long periods ahead, and so require a higher interest rate to offset the risk that yields will be higher than they expected (and so they will be losing out). Shifts in the yield curve may also arise due to hedging activity by investors, whereby they purchase government bonds to offset more risky assets they hold, due to the (virtually zero) low chance of default, and the high liquidity of bonds. Moreover, the fact that government bonds have a very low chance of default – with the UK never having defaulted on its government bonds; in the worst-case scenario a central bank can simply print money to meet bond commitments – may mean that the yield curve underestimates yields, because they haven’t placed a high enough risk premium. A final critique is that the legal structure of certain institutions (banks and pension funds) means they are required to hold a certain percentage of “safe” bonds, mainly consisting of government bonds. This means that they hold the government bonds regardless of yields, and so their expectations about future economic growth are unimportant in their (necessary) purchase of bonds.

Estrella and Mishkin find that “The yield curve has predicted essentially every U.S. recession since 1950 with only one “false” signal, which preceded the credit crunch and slowdown in production in 1967.” Like much of the preceding evidence given so far, this suggests that the yield curve is particularly successful in predicting economic recessions, but this doesn’t necessarily test its predictive power for the future of economic activity as a whole. Hence we conclude that the yield curve is a useful predictor for extreme economic phenomena, such as recessions, but we are lacking evidence to state that it is a good overall indicator of economic activity.

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