Yield curve points to recovery
A reading of US interest rates suggests the US economy should be returning to growth fairly soon and could grow quite strongly thereafter.
Financial markets are currently fretting about the sharp rise in bond yields - and US long-term bond yields in particular.
US bond yields came under pressure again last week with lacklustre bond auctions, inflation fears, a falling US dollar and widening CDS spreads on US sovereign risk, all driving the process. But while all this was happening, the shape of the US yield curve is giving another message - the US recession should soon be over.
To assess just how the yield curve fares as a leading indicator of investor expectations and economic activity, the Federal Reserve Bank of New York undertook a study in 2006 and found that there is indeed a certain robustness to the relationship between the yield curve and economic activity.
The FRBNY explained that the yield curve reflects both monetary policy and investor expectations, with investors' expectations of future short-term interest rates related to future real demand for credit and future inflation. Investor expectations make the yield curve more forward looking than other indicators.
That said, the FRBNY noted that the yield curve is very sensitive to financial market conditions, with the precise impact of changes in conditions depending on whether they stem from technical factors or economic fundamentals.
Demand for certain securities can affect the yield curve for a short period of time. Therefore, the signals produced by the yield curve need to be persistent to be meaningful, ideally being obvious for a quarter or more.
For the purposes of the study, the FRBNY looked at data from January 1968 through to July 2006 to determine how well the yield curve predicted recessions, in particular.
Recessions were defined as those declared by the National Bureau of Economic Research, and the FRBNY defined the yield curve as being the spread between three-month Treasury bills and 10-year US government bonds, the data for these two securities being consistent and readily available.
Using monthly average data for the period removed the noise generated by short-term market fluctuations, allowing a focus on overall trend.
The FRBNY found that it was the level of the term spread that provided the most accurate signal of a forthcoming recession - corresponding to a forward looking expected change in interest rates. The magnitude of the change in the spread was not found to be particularly indicative.
For the period studied the FRBNY found that a negative spread - that is, an inverse yield curve - was predictive of a recession approximately 12 months later 69 per cent of the time. But more critically now, a positive spread was not followed by a recession approximately 12 months later, 85 per cent of the time.
It could be argued that the yield curve is not a reliable predictor of economic activity at the moment because things are different now. But the 'this time it's different argument' has never been a good argument.