The yield curve is a measurement of the relationship between short-term and long-term interest rates. When long-term rates are high relative to short-term rates, the economy is typically strong. The opposite case is not so rosy—when short-term rates are higher than long-term rates, a recession is often in the offing.
Mark Hulbert of Marketwatch makes this point about the yield curve in a recent column. He writes:
You’re wrong if you think that interest rate increases over the last month are bad for the stock market.
That’s because not all rate hikes are created equal. And the kind that we’ve seen over the last month is not the type that typically kills a bull market.
In fact, a strong argument can be made that the last month’s rate increases are actually good news for the stock market: Because the greatest increases have come at the longer end of the maturity spectrum, the yield curve in recent weeks has become steeper — just the opposite of the direction it would be heading if the odds of a recession were growing.
Later in the article, Mr. Hulbert quantifies the chances of a recession based on the yield curve indicator.
It’s a shame that because of concern that the yield curve might be manipulated, many in recent years have tended to dismiss its utility as a leading economic indicator. Its record, in fact, has been creditable — if not impressive.
Consider one famous econometric model based on the slope of the yield curve that was introduced more than a decade ago by Arturo Estrella, currently an economics professor at Rensselaer Polytechnic and, from 1996 through 2008, senior VP of the New York Federal Reserve Bank’s Research and Statistics Group, and Frederic
Mishkin, a Columbia University professor who was a member of the Federal Reserve’s Board of Governors from 2006 to 2008. The model last spiked upward in late 2007 and 2008, when it gauged the odds of a recession at more than 40% — just before the Great Recession. Click here to go to the page of the NY Fed’s website devoted to this model.Today, in contrast, the model is reporting the odds of a recession in the next 12 months at a minuscule 2.5%.
Now, I have no way of knowing or even guessing if the yield curve will be accurate this time around, but it’s worth noting in the sea of bearishness surrounding the recent increase in long-term interest rates. When pundits are nearly unanimous, it’s always worth considering if the opposite might in fact be the case.
