What Is The Yield Curve Forecasting?

Macromania explains….It’s well-known that in the United States, recessions are often preceded by an inversion of the yield curve. Is there any economic rationale for why this should be the case?

Most yield curve analysis makes reference to nominal interest rates. Economic theory, however, stresses the relevance of real (inflation-adjusted) interest rates. (The distinction does not matter much for the U.S in recent decades, as inflation has remained low and stable). According to standard asset-pricing theory (which, unfortunately for present purposes, abstracts from liquidity premia), the real interest rate measures the rate at which consumption (a broad measure of material living standards) is expected to grow over a given horizon. A high 1-year yield signals that growth is expected to be high over a one-year horizon. A high 10-year yield signals that annual growth is expected, on average, to be high over a ten-year horizon. If the difference in the 10-year and 1-year yield is positive, then growth is expected to accelerate. If the difference is negative–i.e., if the real yield curve inverts–then growth is expected to decelerate.

(Only 12bps to go. US 2s/10s yield curve drops to 12bps, lowest since 2007.)

What is the economic intuition for these claims? One way to think about this is in terms of Friedman’s Permanent Income Hypothesis, which states that an individual’s desired consumption expenditure today should depend not only on current income but the likely path of his/her income over the foreseeable future. The logic of this argument follows from the assumption that people are willing and able to smooth their consumption over time, given their expectations about how their incomes are likely to evolve over time. For example, if people expect their income to be higher in the future, then they will want to consume more today in order to smooth out their consumption. They can attempt to do so by saving less (or borrowing more). If a community is collectively “bullish” in this sense, desired consumer spending should rise in the aggregate, and desired saving should fall, leading to upward pressure on the real interest rate.

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Kurt Benson 4 months ago Member's comment

Good read, thanks.