Introduction
The series of recessions that have occurred in the past decades have raised several questions about the effectiveness of the various existing measures of recession, some of which use a comprehensive set of indicators. A number of analysts have stressed that financial market indicators provide a more effective predictions about recession. In this respect the predictive capacity of the bond yield curve have received much attention in recent times. The current discussion sheds some light on the predictive capacity of the yield curve and the associated term spread. Current scenario is studied in terms of the yield curve obtained from present yield rates. The study suggests that the financial market is not yet caught in the blues and holds strong in the face of current monetary policy shifts in terms of quantitative easing.
The Yield Curve
The yield curve is often termed as an almost accurate tool for economic forecasting. This is a curve obtained by plotting the yield of the Treasury bonds against their maturity. The slope of the yield curve gives valuable information about the future performance of the economy. A negative slope on the yield curve is fraught with danger as it suggests the onset of a period of recession. (Haubrich & Dombrosky, 1996).
Inferences bout future growth perspectives and even the rate of inflation can be drawn from the slope and shape of the yield curve. It is a reflection of the current monetary policy. A flattened yield curve denotes a rise in short term rates indicating a slowdown in near future. (Estrella & Mishkin, 1996). It has been observed by researchers that the changes in market expectations about future short term rates has a direct bearing on the slope of the yield curve. The fear of a future recession and its magnitude and duration influences the expectations about short term future rates which is an important factor responsible for the predictive capacity of the yield curve. (Dueker, 1997). Studies have conclusively proved the predictive power of the yield curve. Chauvet & Potter(2001) have used the probit model to construct probabilities of recession occurring in 2001 and have shown strong evidence of the predictive capacity of the yield curve.
The Yield Curve as on June 2014:
The table below shows the yield on US treasury bills as on June 2, 2014. The yield curve obtained from the table is given subsequently.
What the Yield Curve Suggests
The yield curve is flat at the short end but upward rising at the long end. This suggests that there is less likeliness of a recession in future and the market confidence is holding on. The GDP is expected to show positive growth in the future. But it should also be emphasized that this growth in GDP will be inflationary in nature as the slope of the yield curve is somewhat steep on the higher side.
There are a number of ways of predicting recession from a yield curve. One standard measure is to obtain the difference between two rates also known as term spread, which is discussed in the following section.
The Term Spread and its Implication:
The term spread is the difference between the long-term yields and the short-term yields. It gives a measure of the spread between current short term interest rate and the average expected future short-term rates. It is a reflection of the current monetary policy stand taken by the fed. A higher spread indicates a more restrictive monetary policy. (Wright, 2006).
In terms of the expectation hypothesis long-term rates can be viewed as the average of expected future short term rates. According to this hypothesis the yield at time t on an n period bond Ynt is given as:
If we are to associate low interest rates to recession, then lower upcoming rates will predict recession. According to policy anticipations hypothesis, since policy makers tend to reduce short-term interest rates during recession, when market participants anticipate a recession they expect the future rates to be lower, hence a downward plunge of the yield curve indicates a spate of market pessimism and harbinger of recession.One explanation for this is that, a tight monetary policy may raise short-term rates thereby flattening the yield curve leading to slowing down of the economy. Though from the current discussion it might seem that the yield curve or the term spread is a representation of the monetary policy only, it should be kept in mind that the monetary policy itself reacts to changes in output. So the yield curve is actually a reflection of complex events occurring in an economy. (Haubrich & Dombrosky,1996).
The term spread between the interests of 10 year and 3 month treasury bills is 0.98 percentage points. According to the estimates of the probability of recession by Estrella and Mishkin(1996) the probability that the economy will move into recession in next three to four quarters is around 5, which implies the economy is less likely to move into recession in the June of 2015.
The quantitative easing policy is expected to bring down long term rates or to put it in the other way, the average expected future short term rates. This is expected to bring pessimism in the market leading to a downturn in the yield curve suggesting future recession. But studying the present yield curve and the term spread we cannot find such an indication yet.
The term spread calculated according to current rates was 0.98percentage points. Interestingly, calculating the term spread in December 2, 2013 we get the same result that is 0.98 percentage points. Comparing the term spread as on June 2, 2014 and December 2, 2013 we find that the term spread has not changed significantly. This may imply the investors expect a more or less constant interest rates, which suggests that the mood of the market participants have not changed in the last six months. The market confidence is still holding on has not received any severe setback.
Conclusion
The present discussion rests on the importance of the yield curve and the term spread in predicting the onset of a period of recession. It also uses these two tools in predicting the probability of recession in the present scenario of quantitative easing by the Fed. Inspite of the discussions which suggest the success of the yield curve as an effective predictor of recession we are faced with the question that in the backdrop of a large set of macroeconomic indicators and econometric tools why do we need to rely so much on the yield curve? In this respect it should be noted that the yield curve is not only simple to derive and less time consuming to analysis it also acts as a supplement to the existing indicators of growth and recession. Also it is to be stressed that the yield curve can give us an idea about the future of the economy at a glance and the probability of recession can be calculated by computing the term spread from the curve itself. The value of the tool lies in its simplicity as well as its effectiveness. In addition to that this tool can be used to cross check the econometric analysis and macroeconomic forecasts on growth and recession. (Estrella and Mishkin,1996) At the end it remains an elegant but simple tool to know whether we have to be cautious about a future recession or rest assured that it will be business as usual,
References
Chauvet, M & Potter, S. “Predicting A Recession: Evidence From The Yield Curve In The Presence Of Structural Breaks”. April 2001. Rsearchgate.net. June 6,2014.
Dueker, M.J.(1997) “Strengthening the Case for the Yield Curve as a Predictor of U.S. Recessions”. Review, March/April1997.
Estrella, A. & Mishkin, F.S.(1996) “The Yield Curve as a Predictor of U.S. Recessions”. Current Issues in Economics and Finance. Vol.2”(7). June 1996. Federal Reserve Bank Of New York.
Haubrich, J.G., & Dombrosky, A.M.91996). “Predicting Real Growth Using the Yield Curve”. Economic Review1996Q1. http://cleveland.org/research/review. 6 June 2014.
Wright, J.H.(2006) “The Yield Curve and Predicting Recessions”. Finance and Economics Discussion Series, Divisions of Research and Statistics and Monetary Affairs, Federal Reserve Board, Washington D.C.
