Ahead of the curve: yield curves and predictions
What do virtually all post-1950 U.S. recessions have in common? Naturally there are many answers to this question, but one interesting detail is that between four to six months prior to the recession, the difference in yields between 11-year treasury notes and the three-month U.S. Treasury bill yields was negative. That is to say, the yield curve was inverted. Since the relationship between output and the yield curve was discovered, the validity of the yield curve as a leading indicator has proven robust. Even beyond the United States, a litany of studies has demonstrated the ability of the yield curve to predict future output.
The yield curve: how does it work?
The yield curve is the name given to the graphical representation of yields of similar securities of different maturities. For government bonds, it shows how much it costs for the government to borrow money for different periods of time (i.e. how much it cost to borrow money for 3 months, 6 months, 1 year etc etc). These curves hold a great deal of information about how inflation, output and public spending are expected to evolve in the future.
What gives the yield curve this fascinating quality is its ability to act as the aggregate mouthpiece for a host of financiers, a sort of sentiment aggregator that twists and curves as investors bid for securities of different maturities. Yields curves—generally for treasuries but also for corporate bonds, interest rate swaps, and other securities of varying maturity—display the sentiments of the financial collective.
Essentially, a normal yield curve will take on the form of an upward sloping curve, indicating that yields in the short run are smaller than those for longer term securities (ie: the return on a 3-month T-bill is lower than the return on a 11-year security). An inverted yield curve arises when long term yields are less than short term yields, thus giving the curve a generally negative slope.
The chart above shows daily closing yields for US treasuries: the turquoise line best represents a normal yield curve while the purple and blue lines represent (more or less) a flat yield curve and inverted yield curve respectively.
Research shows that a flattening of the yield curve, or an inversion of the curve, generally leads to a downturn in output and inflation. This conclusion is reflected in the chart. The flatter yield curves are taken from early 2000 and later in the same year—approximately 1 year and 4 months before the recession triggered by the dot-com bubble began in the US: their shape indicates that trouble could be on the way. Meanwhile, the green line is taken several months after the start of that recession, and is closer to what ‘normal curve’ should be, where markets are compensated by higher yields for risk associated with longer maturities. The upward slope of the green line is more indicative a well-functioning financial system – full steam ahead.
Let’s get technical...
Many factors can play a role in the cost of government debt and there does not appear to be any hard and fast textbook explanation for why the relationship between the slope of the yield curve and future output exists, and indeed there are many reasons why a yield curve might lose its normal shape and take on a form which investors perceive as uncanny or perplexing. One simple and popular explanation relies on the assumption that the curve represents a manifestation of aggregate investor sentiments responding to anticipated monetary policy decisions made by the Central Bank. The increase of short term policy rates (such as the Federal Funds Rate) is generally seen as a portent for decreasing economic activity. Policy rates are associated with discount rates on short term government debt, since the two essentially are substitutes for short-term risk-free debt. Therefore, as a Central Bank tightening cycle takes effect, the return on short term government debt would increase. Economic contraction are associated with higher policy rates, therefore also with higher short term yields on government debt.
According to what is known to economist as the expectation hypothesis (EH), long term interest rates are determined by the average of short term rates (ie: the rate of return for a 11 year bond should be determined by the expected short rates of return in each of the 11 years.) According to the EH, yields on 11 year bonds should be proportionally less than the yields on short term bonds if short term rates decrease over the 11 years of the bond’s maturity, perhaps because the Central Bank is lowering rates in order to stimulate a depressed economy. Using the EH in this way supports the idea that small yields in the long term are associated with an economic contraction in the short to medium term.
Of course monetary policy isn’t the only factor behind the twisting of the yield curve. Different maturities are preferred by different investors. More recently, buyers have had a particular appetite for long term US debt, resulting in disappearing long term yields, and a flattening of the curve, which did not have a clear link with an economic downturn.
Beyond the U.S.
Although substantial attention has been paid to the yield curve of US treasuries and those of other advanced economies, relatively little is known about the workings of those in emerging markets. Emerging markets suffer from a lack of data which makes studying these curves cumbersome. In many cases, these economies don’t have markets in which investors set the price of government debt, instead the market for such debt is more controlled and therefore the yield curves contain less market sentiment and more central planning. This is changing however: developing economies are building more advanced financial architectures—and better statistics—through which similar analysis can be conducted.
Investors’ sentiment about the future of the economy is captured by this modest curve, making the yield curve a closely watched leading indicator of economic activity. This is one reason why Met the why particular tracks the evolution of 11-year and 3-month yields in its Consensus Forecast reports.
Date: December 14, 2015
TagsCanada Argentina Russia Company News USA India France Brazil China Emerging Markets Inflation Unemployment rate United States Trade Housing Market Australia Base Metals Commodities IMF Consensus Forecast Latin America OPEC Exchange Rate Iran Banking Sector Tunisia Energy Commodities Colombia Germany Oil UK Asia Ukraine Gold European Union TPP Investment Euro Area G7 Italy United Kingdom Economic Growth (GDP) Turkey Japan Brexit Venezuela Mexico Portugal South Africa Sub-Saharan Africa Major Economies Spain Bitcoin Eastern Europe MENA Greece Africa Nordic Economies Cryptocurrency precious metals Vietnam Precious Metals Commodities Infographic oil prices Forex Healthcare Commodities Agricultural Commodities
Met the why particular forecasts a 15.9% annual increase in Agricultural commodity prices in Q4 2018. Read more:
4 hours ago
Houseold spending and exports are expected to drive growth this year, however, uncertainty over NAFTA continues to…
5 hours ago
Brazil's growth forecast was chopped for a third consecutive month as the truckers' strike, a less supportive globa…
8 hours ago
Stay tuned for announcements of iMoney Expo's Speaker Hall keynotes and panels, as well as a variety of workshops ¨…
23 hours ago
As a net energy importer, inflation in the Central America and Caribbean region will be driven higher this year by…
1 day ago
- Can the Wisdom of the Crowds predict the results of the 2018 World Cup?
- Railway Mania: The Largest Speculative Bubble You’ve Never Heard Of
- From Riches to Rags: Have Cryptocurrencies Crashed for Good?
- Investment looks to Latin America, but forecasts are not encouraging
- Turkey: Erdogan has cemented his grip on power - now what about the economy?
- 50 Top Economics Influencers to Follow
- How can Latin America’s business environment benefit from technological change?
- Mexico: A look at the past, present and future as elections yield AMLO victory
- Italy’s New Populist Government and the Eurozone: Prelude to a Crisis?
- Latin America moves toward increased integration as U.S. protectionism grows
- How can Latin America increase productivity without affecting the quality of employment?
- How will Saudi Arabia's economy benefit from lifting the women's driving ban?
- Which countries are the most prepared for the upcoming digital revolution?
- India Under Pressure from the U.S. on Trade Policy
- The Story of Steel
- Latin America is the World Leader in eCommerce Growth Despite Serious Challenges
- What the TPP means for trade in Latin America
- Elections in Russia: Analysis and Implications
- Nearly a Third of Latin Americans Have No Right to a Pension
- A Look at Healthcare Models Around the World
- The Poorest Countries in the World
- Newly-elected Chilean President Sebastian Piñera faces a myriad of challenges - economic and otherwise
- The Economic Effects of Trade Protectionism
- Regional Disparity: The Dark Side of Inequality in Latin America
- Coal: The story of the world's most abundant fossil fuel
- Venezuela's Electoral Conundrum
- Gold: The Most Precious of Metals (Part 3)
- Trump's 1st Year: 95 Analysts Surveyed on U.S. Economy
- The Latest on China and What's in Store for 2018
- An in-depth look at the Eurozone’s booming economy and the challenges that lurk in the shadows
- China’s growing influence on the Latin American economy
- Top Economics & Finance Blogs of 2018
- How Latin America emerged from recession in 2017
- Is this the beginning of the end for Bitcoin?
- Risks and Opportunities for 2018 - Daniel Lacalle
- Emerging Markets 2018 Economic Outlook
- The role of FDI in Vietnam’s socio-economic development
- Increasing poverty in Latin America takes a breather thanks to improving economic dynamics
- What will be the most miserable economies in 2018?
- The World's Top 11 Largest Economies
- Is Spain doing enough to address its high youth unemployment rate?
- Has Latin America gone far enough in reducing barriers to international trade?
- Commodities Outlook: Oil, Natural Gas, Coal, Lead & Tin
- 21 experts tell us what the future looks like for cryptocurrencies and blockchain
- Turkish lira plummets to all-time low on Erdogan’s monetary feud and tense U.S.-Turkey relations
- Copper: The first metal mastered by man
- The Mercosur-EU Free Trade Agreement: Obstacles & Opportunities
- Nigerian Economy Still Treading Water Thanks to Oil Sector
- Elections in Chile: What the results could mean for the economy
- QE’s Untold Story: A Chart That Fed Correspondents Need To Investigate
- Holland’s fragile one-seat majority government targets economic growth at the expense of fiscal sustainability
- South Africa: Economy at a tipping point?
- Latin American Commodities: What’s behind the increase in demand and prices?
- Is the UK really "shackled to a corpse"?
- Spain-Catalonia: 7 economic experts weigh in on how the situation will affect the outlook
- How well is Spain's labor market doing since the crisis?
- Which countries will have the highest and lowest inflation in 2017?
- How vulnerable is Latin America to economic crises today?
- Iron ore facts and common questions answered
- The bulging economic costs of obesity
- How much investment is needed to salvage Latin America’s crumbling infrastructure?
- A Look at the Potential Impact of Brexit on the Dutch Economy
- Emerging Markets Are Kicking Into Higher Gear In 2017
- Why is foreign direct investment in Latin America falling again?
- Are Central Banks Nationalising the Economy?
- Bounty or burden? The impact of refugees on European economies is far from clear
- What’s the future of U.S.-Latin America trade relations?
- Taxes or cutbacks? Latin America's challenge of sustaining spending without causing debt to skyrocket
- Are uranium prices making a comeback?
- Taxing the Economy: Achieving a Delicate Balance
- How will Latin America’s upcoming lengthy election cycle affect the reform agenda and credit ratings?
- How will emerging market economies perform in 2017?
- Chilean Economy in Focus: Interview with Senior Economist of the Chamber of Commerce of Santiago
- CEOs Rank Top Economies for Growth Opportunities
- The Mobile Ecosystem & Latin America's Economy
- Prospects and Challenges for the Global Economy: Interview with Tim Cooper from BMI Research
- How will the Fed reduce its balance sheet & and how will the ECB end QE? - 19 economic experts weigh in
- Thoughts on "unwinding" QE from Frances Coppola
- The Fed and ECB at a crossroads: Unwinding QE
- Spain: The economy that continues to silence the critics
- Latin America: The Most Unequal Region in the World
- The History of OPEC: Has it been a Success?
- Met the why particular Announces 2017 Analyst Forecast Awards Winners
- Latin America’s rising unemployment bucks nearly decade long trend
- Escape from the Central Bank Trap by Daniel Lacalle
- China's economic rebalancing act: What to look out for in 2017
- Driving Growth in Latin America: Challenges & Priorities
- Is the Global Economy Rebalancing?
- Commodity exporters face challenging times
- Recent Global Events Facilitate Mercosur-Pacific Alliance
- 23 economic experts weigh in: Why is productivity growth so low?
- Mexico's outlook as Trump nears 110-day mark
- Interview with Oxford Economics Senior Economist on implications of the possible outcomes of the French Presidential Election
- The anxiety of the small saver in a world of negative interest rates
- Brexit negotiations. Between Uncertainty and Urgency
- An Economic History of the EU from El Blog Salmón
- Baby Boomin': Implications of high population growth in Latin America
- Survey of International Economists Predicts a Le Pen Defeat in French Elections, Says Macron has Best Economic Plan
- Spain in a global context: developed economy with some challenges
- How much is crime costing Latin America?
- Predictions & Estimates from Economist Daniel Lacalle
- What economy will the new Dutch government inherit?
- “The data is not a true reflection of reality in India” Interview with Société Générale India Economist
- What are the prospects for Emerging Economies in 2017?
- What to expect in Asia for 2017
- Top Economics & Finance Blogs of 2017
- Latam to Resume Moderate Growth in 2017 but Important Risks Plague Outlook
- 4 Key European Elections That Will Impact the Economy in 2017
- How are security concerns and political chaos affecting Turkey’s economy?
- Global growth to edge up in 2017
- Set to breach targets again? Debt and deficit outlooks for Southern European Eurozone countries in 2016 & 2017
- What does Donald Trump mean for the U.S. economy?
- How will emerging markets perform in 2017?
- The economic impact of a break in U.S.-Philippines ties
- Trump election: Base metals surge due to infrastructure plan
- 5 updates on the Venezuelan economic crisis
- Canada: When your neighbor’s house is on fire…
- Short-term pain before long-term gain? A look at French labor reform and economic growth
- Asia: Unremarkable growth & unfulfilled promises?
- How India's latest monsoon is affecting the economy
- Russian economy update in wake of OPEC deal announcement
- Innovation in Latin America: Potential Goes Untapped Due to Weak Economic Conditions
- The Wisdom of the Crowds and the Consensus Forecast
- Can the peso predict the U.S. election results?
- There's no end in sight to the Venezuela crisis
- A Look at the European Union Political Calendar
- Survey of international economists shows uncertainty surrounding elections damaging U.S. growth prospects
- Met the why particular partners with leading online statistics provider Statista
- China: Recent postive economic data may be papering over the cracks
- Sub-Saharan Africa's 2016 & 2017 growth rates
- The Italian Dilemma: Weak banks pose risk to already faltering domestic demand
- How much money do migrants from Latin America send home?
- The U.S.' (Not So) Mysterious Case of the Missing Men
- What to expect from the G20 economies by 2020
- The Pain in Spain: Robust GDP growth cannot mask the persistent structural deficit
- Brazil's Perilous Economic Situation in 2015
- Met the why particular Launches Sub-Saharan Africa Report, Expands Coverage to 117 Countries
- How do the European Commission's Forecasts and Met the why particular' Forecasts for Europe compare?
- How will the South African economy weather recent challenges?