Predictive power of the yield curve

Peter Elston

Peter Elston

Nature has many warning signs for when danger is near.

Rapidly retreating water at the beach or brightly coloured creatures in the jungle are clear indications of danger, whether warning of a tsunami or the ability to poison.

Cause and effect in these instances are proven, as they are in so many other aspects of nature, science and even economics.

It is, therefore, somewhat strange that there has been a recent trend of respected economists rejecting a once sure-fire way to predict recessions – the inversion of the yield curve.

A yield curve is a graph which represents interest rates for a range of maturities.

The yield is plotted on the vertical axis and the time to maturity across the horizontal.

The curve is typically upward sloping, indicating that short-term interest rates are lower than long-term interest rates – a relationship that tends to promote a balance between saving and investment.

While curves exist for various markets, the most important is the curve of government or safe-haven bonds.

This is because these so-called risk-free rates are the basis of pretty much everything in finance and so are the key ones to keep track of.

While short-term risk-free rates that determine deposit and lending rates are priced off the central bank policy rate, longer term rates are determined by the market and represent the risk-free returns that savers willing to commit for the long term can enjoy.

When low short-term interest rates lead to an overheating economy, central banks must increase the policy rate.

If this is prolonged, and short-term interest rates rise above long-term interest rates, the yield flattens, and eventually inverts. This can be either because the short-term rate is rising or because the long-term is falling.

The flattening of yield curves around the world in recent months has been largely due to the latter.

In other words, the fall in long-term interest rates is signalling that the global economy is facing weakening growth expectations. Moreover, the anecdotal data supports this.

Quantitative easing (QE) programs over the past decade were designed to depress long-term interest rates, and as such – some economists argue – have artificially distorted the yield curve to the point that it can no longer serve as a predictor.

I would argue that so-called QE programs have indeed distorted yield curves, but in such a way that they become more of a predictor, not less.

The ending of QE programs represents a de facto tightening of monetary policy and can therefore be considered as an effective increase in policy rates.

However, it is an increase in policy rates that does not show up in the yield curve.