Yield Curve Inversions and Future Economic Growth

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Yield Curve Inversions and Future Economic Growth
Updated April 13, 2006

• Campbell R. Harvey
• Duke University, Durham, NC USA
• National Bureau of Economic Research, Cambridge
  MA USA
• Cam.harvey_at_duke.edu
• 1 919.660.7768 office 1 919.271.8156 mobile
• http//www.duke.edu/charvey

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Issue

• Certain parts of the yield curve have inverted
  which means short-term rates are higher than
  long-term rates
• Yield curve inversions were the topic of my 1986
  dissertation at the University of Chicago
• I developed a model based on work by Breeden
  (1979) that linked inversions to future economic
  recessions
• Are we headed towards a recession?

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Historical Track Record

• The measure attracted significant attention in
  accurately forecasting the recession of July
  1990-March 1991.
• The measure also avoided false signals (for
  example, it forecasted strong growth in 1988
  after the October 1987 crash and it forecasted
  strong growth in 1999 after the August 1998
  financial crisis).

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Evaluation of the Last Recession

• In July 2000, the Yield Curve inverted
  forecasting recession to begin in June 2001.
• Official NBER Peak is March 2001 (Yield Curve
  within one quarter accurate).
• In March 2001, the Yield Curve returned to normal
  forecasting the end of the recession in November
  2001.
• On July 17, 2003 the NBER announced the official
  end of the recession was November 2001.

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Exhibit 1
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Exhibit 2
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Yield Curve Inverts Before Last Six
Recessions(5-year Treasury note minus 3-month
Treasury bill yield-secondary)
Annual GDP growth or Yield Curve
Real annual GDP growth
Yield curve
Recent flattening
Recession Correct
Yield curve accurate in recent recession
Recession Correct
Recession Correct
2 Recessions Correct
Data though April 11, 2006
Source Campbell R. Harvey. Update of Harvey
(1986, 1988, 1989).
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Yield Curve Inverts Before Last Six
Recessions(5-year Treasury note minus 3-month
Treasury bill yield constant maturity)
Annual GDP growth or Yield Curve
Real annual GDP growth
Yield curve
Recent flattening
Recession Correct
Yield curve accurate in recent recession
Recession Correct
Recession Correct
2 Recessions Correct
Data though April 11, 2006
Source Campbell R. Harvey. Update of Harvey
(1986, 1988, 1989).
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Recent Annualized One-Quarter GDP Growth
(10-year and 5-year Yield Curves-secondary
market)
Annualized 1-quarter GDP growth
Yield curve
10-year
Real annualized one-quarter GDP growth
5-year
Both curves invert 2000Q3
Data though April 11, 2006
10
Recent Annualized One-Quarter GDP Growth
(10-year and 5-year Yield Curves-constant
maturity)
Annualized 1-quarter GDP growth
Yield curve
10-year
Real annualized one-quarter GDP growth
5-year
Both curves invert 2000Q3
Data though April 2006
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Current Situation

• 15 consecutive Federal Funds Rate increases yet
  the long-term bond rate has remained relatively
  flat.
• Why?

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Current Situation

• In the past, the Federal Reserve Bank had some
  control over long-term as well as short-term
  interest rates. Long-term rates could be impacted
  with its open market operations.
• Given the dramatic increase in the size of the
  debt market, control is now limited to the Fed
  Funds rate.
• The behavior of the long-term rate is a
  conundrum as Former Chairman Greenspan
  remarked. Obviously, in the recent Fed
  tightening, they were planning on the long-term
  rate to increase. Long-term rates did not
  increase over 13 hikes.

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Current Situation

• Fed Playing Catch Up With Short Rates. For an
  extended period of time, the Fed Funds rate was
  negative (on an inflation adjusted basis). This
  means that borrowing was subsidized by the
  government. At least 10 of the Fed rate hikes had
  no impact, because they were playing catch up.
  That is, they were moving the rate to where it
  should have been. This is why the last two hikes
  have had bite. Long rates moved up as soon as
  the Fed hiked.

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Current Situation
2. Weaker economic growth. Consistent with my
yield curve model, the lower long-term rate
signals lower expected growth. The lower growth
is consistent with the ISM index hovering just
above 50. There are growing signs of a housing
slowdown with Mortgage Applications running below
2004 levels new home sales down, housing prices
down, and homeowners with ARMs facing much higher
interest rates.
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Current Situation
3. Inflation perceptions. The long-term rate is a
combination of expected inflation, expected real
interest rates and an inflation risk factor.
Long-term inflation expectations have decreased
mainly due to the glut of cheap labor resulting
from globalization.
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Current Situation
4. Strong buying of long-term bonds by
foreigners. For the past few years, strong buying
by Asian central banks have pushed up the
Treasury bond prices. However, there is a debate
as to whether this has had a large impact on bond
prices. In addition, this buying has flattened
out recently. A recent Fed study estimated that
the foreign buying pushed yields down by 150bp.
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Current Situation
5. Hedge funds. There has been a recent increase
in demand for U.S. bonds from the Caribbean area
indicating hedge fund activity. With long-rates
above short rates, many managers do carry
trades (borrow short-term and buy long-term
bonds hoping the relation between rates remains
stable). As the term structure flattens, many of
these managers increase their leverage which
means more buying pressure on the long-term bonds.
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Current Situation
6. Demographic forces. As the population ages,
more money is allocated into fixed income and
long-term bond yields may decrease. 7. Inflation
risk. The long-rate rates contain expected
inflation, expected real rates and an inflation
risk factor. It is widely perceived that
inflation risk (an unexpected episode of
inflation turbulence) has decreased.
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April 2006

• All three measures of core inflation (PPI, CPI,
  and PCE) key things that new Fed chair will
  follow.
• Evidence of housing cooling. Question of whether
  it will be a soft landing or a hard landing in
  the housing market.
• I fail to see a logic for a 16th hike in Fed
  Funds. Indeed, I did not see the logic for the
  15th. It will take a while for these hikes to
  work their way through the system. Hence, you
  need to stop earlier or you run the risk of
  overshooting and destabilizing the economy.

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April 2006

• Inverting the yield curve (even if it is a false
  signal) will likely increase disagreement among
  market participants because most associate
  inversions with bad economic news
• Increased disagreement will lead to higher VIX
  and corporate spreads
• Increased vol leads to higher costs of capital
• Higher costs of capital lead to less investment,
  employment and ultimately a moderation in
  economic growth

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Recession?

• No inversion yet in key yield spreads calculated
  from constant maturity basis
• With one more Fed hike, we could see an inversion
• If inversion occurs, model would forecast
  recession beginning in Q3 2007.

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Yield Curve and GDP Research Chronology

• Campbell R. Harveys Ph.D. Thesis, University of
  Chicago, 1986.
• Campbell R. Harvey, The Real Term Structure and
  Consumption Growth, Journal of Financial
  Economics, 1988
• Seven other works found at
• http//www.duke.edu/charvey/research_term_struc
  ture.htm