Rates and the curveGrowthMonetary policy
(Don't Fear) The Yield Curve
Eric Engstrom and Steve Sharpe, Board of Governors of the Federal Reserve System (FEDS Notes) · 28 Jun 2018
Why it matters
Every rates interview eventually asks whether an inverted curve predicts recession. This note shows which part of the curve carries the signal and why, which turns a cliché into an argument.
What it says
Two Fed Board economists test which slope of the Treasury curve actually forecasts recessions. They compare the familiar long-term spreads, such as 10-year minus 2-year, with a near-term forward spread: the forward rate on bills six quarters ahead less the current three-month bill yield. Because that forward spread tracks where the market expects policy rates to go, a negative reading means investors expect the Fed to cut, usually because they expect activity to weaken. In probit models on quarterly data from 1972 to 2018, the near-term spread is highly significant while the long-term spread adds little once it is included, and the same ranking holds for forecasting GDP growth. The authors read this as reverse causality: the curve predicts recessions because it already contains the market's expectation of easing, not because an inversion causes the downturn.
What to take from it
- 1
The near-term forward spread compares the implied bill rate six quarters ahead with today's three-month bill yield, so it isolates expected policy moves rather than the whole curve.
- 2
A one standard deviation fall in the near-term spread, about 80 basis points, raised the modelled probability of recession by 35 percentage points.
- 3
Once the near-term spread is in the model, the long-term spread's effect on recession odds is economically small and statistically indistinguishable from zero.
- 4
Long spreads can be moved by forces irrelevant to recessions (the authors suggest a secular decline in the inflation risk premium), which dilutes their signal.
- 5
The interview answer: an inverted curve signals that markets expect rate cuts, it does not cause the downturn it anticipates.
Put it to work on L3VLUP
The summary and takeaways are L3VLUP’s reading of the publication, not the publisher’s own words or views.
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