The short answer to the title question is yes. The long answer ends with a resounding maybe. If economics were simple, Ben Stein wouldn't be a nerd's paragon of mathematical virtue, a game show host and the guy that monotones the name "Bueller" twenty times over in Ferris Bueller's Day Off.
As stated above, the yield curve is simply a representation of interest rates of like-kind debt investments (such as Treasury bills and bonds) over varying maturity dates. Connect the dots between the shortest-term facilities and the increasingly longer-term investments, label the x-axis with units of time and the y-axis with interest rates and voila! A yield curve is born.
The graph associated with this article represents a normal yield curve. The following are definitions of the four primary shapes of yield curves:
Normal
The normal yield curve is a positively (upward) sloping series of data points — i.e., as maturities lengthen, interest rates increase. The incremental increases begin to flatten out after the initial steep portion of the curve in the early stages of the maturity profile, with the differences virtually insignificant by the end of the curve. When this situation occurs and holds for significant periods of time, the economy is generally stable and growing at a sustainable pace.
Flat
A flat yield curve represents virtually identical rates for short, intermediate and long-term maturities. This stage often represents a transitional phase in the economic landscape.
Steep
A steep yield curve occurs when the gap between short and long-term rates is extraordinarily wide. The situation normally occurs early in post-recessionary environments when future growth, along with the potential for burgeoning interest rates, is on the horizon.
Inverted
An inverted yield curve is a relatively rare scenario whereby short-term interest rates exceed long-term rates. It tends to invert when short-term rates are on the rise.
The Yield Curve as a Predictive Tool
Varying factors contribute to the rise and fall of interest rates, both on the short and long ends of the spectrum. While short and long-term rates often shift together in tandem, they can likewise move in opposing directions simultaneously. In other words, short-term rates can rise at the same time long-term rates fall — and vice-versa. Given that interest rates are manipulated as a matter of monetary policy, the question becomes this: can the shape of the curve serve as a predictor of future economic activity?
A possible answer lies in key economic data within the following highlighted periods of recent U.S. history: 1977-1983, 1989-1992, 1999-2003, and 2005 to the present.
1977-1983
During this period, the yield curve went from normal in March of 1977 to inverted in November of 1978. It remained negatively-sloped until May, 1980, a full nineteen months later. The era was punctuated by an unprecedented rise in short-term interest rates; the prime rate, which moves with concert with the Federal Reserve's changes to the Fed Funds rate, exploded from 6.25% to 21.5% in the span of 3 1/2 years. While real GDP growth remained strong throughout the first quarter of 1979 (averaging over 6% on an annualized basis), it plunged thereafter, turning negative for four consecutive quarters in 1980. After a tepid recovery, the economy double-dipped into a second recession in 1982. The term stagflation was born, as unlike a garden-variety recession, inflation surged at the same time as growth diminished. A sustainable recovery did not occur until the second half of 1983.
1989-1992
Characterized by the S&L crisis, which was in full bloom during this period, the yield curve tipped into the negative in early 1989 and remained flat or inverted for approximately 18 months. At the time the curve tilted, real GDP was still growing at a solid 4.1% annualized rate. However, the economy lost steam as the year progressed and throughout the next, before posting negative growth for three quarters in 1991. The economy rebounded in 1992.
1999-2003
The economy was hit with two staggering body blows during this era: the bursting dot-com bubble and the terrorist attacks that occurred on September 11, 2001. Although the stock market bubble was fueled by a frenzied, speculative run-up in the equity markets, the precursor to the eventual recession was the flattening and subsequent inversion of the yield curve, starting in 1997. GDP growth stayed at or above normal levels until the fourth quarter of 2000, when it slowed dramatically. Growth became anemic in 2001 and continued at subnormal levels until the end of 2003.
2005 to Present
Although the economy recovered from the previous recession and despite the unprecedented real estate boom to follow, actual GDP growth never quite posted the same gains it had during the 1990's. This era has been characterized by an exceptionally long period of low interest rates. After normalizing and becoming steep for the majority of the early 2000's, the yield curve tipped and flattened in 2005 and inverted in February, 2006. It vacillated between flat and inverted until the official start of the recession in mid-2007. The economy slowed through the end of the year and the first six months of 2008 before suffering negative growth for six consecutive quarters, the worst showing of the post-war era. The recession was declared officially over by the end of 2009, with the economy growing modestly in 2010 despite generating relatively few jobs. Growth slowed during the first half of 2011, showing signs of a possible double-dip recession. Ironically, the yield curve has assumed a steep shape.
The Inverted Yield Curve Has Been the Most Reliable Predictive Type
A normal yield curve is a general indication of economic health and balanced growth. By itself, however, it does not assume predictive qualities — growth could last for years as it did during the post-recession 1980's, or be unsustainable. A flat yield curve seems to be a pivot point toward impending change, but could go either direction and take an indeterminate period of time in doing so, as it did during the latter half of the 1990's. A steep yield curve has historically served as an indication of strong current and/or upcoming growth (early-to-mid 1980's and early-to-mid 1990's), but the steep curve today would appear to belie that notion. Noteworthy in today's economy is the massive degree of governmental fiscal and monetary intervention over the past few years, which have driven interest rates downward to historically low levels and fueled much of 2010's recovery. As such, the shape of the curve today may be artificially skewed.
The inverted yield curve, on the other hand, led to all four recessionary periods cited in this piece with a lead time of two years or less. Therefore, it appears to be the most predictive of all four types.
Summary
A yield curve is a plotting of interest rates over time for debt instruments of identical risk profiles, the most common being U.S. Treasuries. While the curve shape shifts and changes in response to myriad macroeconomic factors, the inverted yield curve has displayed the most reliability with respect to likely future events within our economy. Next time you see it invert, head for your local cave and hunker down. It's going to be a doozy.
Sources:
- Data360.org (accessed on 8/6/11)
- "The Living Yield Curve", The Wall Street Journal Smart Money (accessed on 8/6/11)
- "History of the U.S. (Fed) Prime Rate From 1947 to Present", www.wsjprimerate.us (accessed on 8/6/11)
Walter McLaughlin - I am a 47-year old commercial banker living in the Seattle area. I am an avid sports fan, but also greatly enjoy writing satirical, ...
Join the Conversation