Is the Yield Curve An Effective Indicator Of Recession?

The yield curve measures the difference between the yields on short-term and long-term bonds, and it has long been considered an effective indicator of recession.^[1] However, its reliability as an indicator came into question during an era of unprecedented monetary stimulus.

Following the Financial Crisis, central banks around the world purchased trillions of dollars worth of bonds in an effort to both put more money into people's hands and also place downward pressure on interest rates. These efforts enjoyed some success, as interest rates stayed close to record lows between 2008^[2] and 2015.^[3]

The Yield Curve Explained

The yield curve illustrates how the cost of borrowing money changes as a function of the time that it is lent out.^[4] More specifically, it displays how these costs change for U.S. Treasuries.

Usually, the yield curve is upward-sloping. In other words, interest rates generally increase as the time needed to pay back the money grows longer.

Lenders require additional money in order to assume the risk of lending over a longer period of time, because future economic conditions are uncertain.^[4] This additional payment is referred to as premium, and as long as this premium remains positive, the yield curve will generally follow an upward slope.

The Yield Curve's Changing Slope

The slope of the yield curve can change. Usually, one-year Treasury notes have lower yields than their 10-year counterparts.^[1] The difference between the yields of these two securities can decrease at times, which is a development that can be described as the flattening of the yield curve.

This curve flattened quite a bit between January 2009 and April 2018, according to Haver Analytics/U.S. Treasury Department data provided by the Brookings Institute.^[4] In the first curve, yields were very low (below 1%) until Treasuries reached a three-year maturity. The second curve shows a different story, as yields are more than 1.5% at every maturity but reach roughly 3% for Treasury bonds with 30-year durations.

Inverting The Yield Curve

Should the yield on the one-year note became greater than that of the 10-year note, that would be referred to as the yield curve "inverting."^[1] Usually, recessions have materialised shortly after this has happened.

However, the significant volume of bonds that central banks bought following the global Financial Crisis compressed yields, which could easily impact the yield curve.^[1] Further, the Federal Reserve hiked short-term interest rates more than once as the U.S. economy recovered following the economic downturn.

In addition, Treasuries may have enjoyed higher-than-usual demand from investors who seemed to be less concerned about inflation.^[1] All of these factors could have undermined the usefulness of the yield curve in predicting recessions.

Summary

Traditionally, the yield curve has been a valuable indicator of recession. Designed to illustrate the difference between borrowing money in the short-term and long-term, the curve helped provide insight in to investor demand for U.S. Treasuries.

Unfortunately, the yield curve may have lost some of its luster as an indicator of a recession, as several variables affected it following the Financial Crisis.