Relationship To The Business Cycle
The slope of the yield curve is one of the most powerful predictors of future economic growth, inflation, and recessions. One measure of the yield curve slope (i.e. the difference between 10-year Treasury bond rates and the federal funds rate) is included in the Index of Leading Economic Indicators.
An inverted yield curve is often a harbinger of recession. A positively sloped yield curve is often a harbinger of inflationary growth. Work by Dr. Arturo Estrella & Dr. Tobias Adrian has established the predictive power of an inverted yield curve to signal a recession. Their models show that when the difference between short-term interest rates (he uses 3-month T-bills) and long-term interest rates (10-year Treasury bonds) at the end of a federal reserve tightening cycle is negative or less than 93 basis points positive that a rise in unemployment usually occurs.
All of the recessions in the US since 1970 (up through 2011) have been preceded by an inverted yield curve. Over the same time frame, every occurrence of an inverted yield curve has been followed by recession as declared by the NBER business cycle dating committee.
|Event||Date of Inversion Start||Date of the Recession Start||Time from Inversion to Recession Start||Duration of Inversion||Time from Disinversion to Recession End||Duration of Recession||Max Inversion|
|Average since 1969||12||12||10||12||−147|
|Std Dev since 1969||3.83||4.72||7.50||4.78||138.96|
Dr. Estrella has postulated that the yield curve affects the business cycle via the balance sheet of banks. When the yield curve is inverted banks are often caught paying more on short-term deposits than they are making on long-term loans leading to a loss of profitability and reluctance to lend resulting in a credit crunch. When the yield curve is upward sloping banks can profitably take-in short term deposits and make long-term loans so they are eager to supply credit to borrowers.
Read more about this topic: Yield Curve
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