The Modified Yield Curve And Growth Prospects Through 2019

It’s kind of limiting to look only at recessions as predicted by the yield curve. What about growth?

I run regressions of 4 quarter GDP growth (in log terms) as a function of one year lagged 10 year-3 month Treasury spread, the spread augmented by one year lagged economic policy uncertainty (EPU, from Baker, Bloom and Davis), and spread augmented by EPU and contemporaneous four-quarter growth in potential GDP.

Figure 1: 4 quarter growth rate in real GDP (dark blue), predicted from 10 year-3 month Treasury spread lagged one year (teal), from spread augmented by EPU lagged one year (red), and lagged spread and EPU augmented with contemporaneous 4 quarter growth rate in real potential GDP (chartreuse). NBER defined recession dates shaded gray. Light orange denotes Trump administration. Source: BEA, Fed, CBO, NBER, author’s calculations.

Notice all forecasts suggest declining growth rates going forward — although the simple yield curve model predicts the least decline, and has the lowest R-squared at 2% over the 1986-2018Q3 period.

The yield curve augmented with economic policy uncertainty has greater explanatory power — R-squared of 8%. And this specification incorporating the estimated growth rate of potential GDP had an R-squared of 33%. Interestingly, these last two models forecast the same y/y growth rate in 2019Q4: 1.5%

All of these forecasts are accompanied by large prediction errors. Figure 2 shows the forecast from the yield curve EPU augmented model, and the 60% prediction interval (+/- 1 standard error). Notice the prediction interval encompasses negative values.

Figure 2: 4 quarter growth rate in real GDP (dark blue), predicted from 10 year-3 month Treasury spread and EPU lagged one year (red), and +/- 1 standard error. NBER defined recession dates shaded gray. Light orange denotes Trump administration. Source: BEA, Fed, NBER, author’s calculations.

Many permutations are possible, including an estimate of the term premium, allowing a level term from the yield curve, and including a credit risk term. All this is just illustrative of what kind of slowdowns are implied by the standard model, and that incorporating one measure of economic policy uncertainty.

Disclosure: None.

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