YIELD CURVE AND ECONOMIC GROWTH

As Arturo Estrella and Frederic S. Mishkin said, “The yield curve—specifically, the
spread between the interest rates on the ten-year Treasury note and the three-month
Treasury bill—is a valuable forecasting tool. It is simple to use and significantly outperforms
other financial and macroeconomic indicators in predicting recessions two to six .



quarters ahead” (“The Yield Curve as a Predictor of U.S. Recessions,” Current Issues in
Economics and Finance, Federal Reserve Bank of New York, June 1996).
Guessing what phase of the business cycle an economy is in is a great game. Is the
economy going into a recession? Since economic data mostly is lagging, we don’t know
we have begun a recession until it actually has begun and been confirmed. However,
sentiment about an expected recession is not stopped by lack of data. One of the most
important measures that traders track is the shape of the yield curve. The yield curve is
defined as the difference between the 10-year Treasury note and the 3-month Treasury
bill. We see here the key role that interest rates play in reflecting expectations in the
market. The Federal Reserve Bank of New York published an important study of the yield
curve and recessions, which included a table relating probability of recession to the yield
curve (Table 3.1). A separate study (see Figure 3.2) shows the strong correlation of the
yield curve as a precursor of a recession 4 months in advance.
We can see that the yield curve provides an important barometer for the future GDP
growth. With regard to the yield curve, what is particularly important to track for the
forex trader is the shape of the yield curve. Is it flat? Is it upward sloping? Is it inverted?
These are the key patterns to observe. In normal times, people are willing to pay more
for longer-term maturities and bonds. This is a natural reaction to the fact that there is
more risk over a longer period of time. But a slowdown or fear of a recession causes
the market to demand higher interest rates for short-term borrowing. The yield curve
becomes inverted. Short-term interest rates become greater than longer-term rates!




FIGURE 3.2 Four-Quarter GDP Growth.
Note: The figure plots 4-quarter GDP growth together with the 20-quarter term spread (upper panel)
and the 1-quarter short rate (lower panel) lagged 4 quarters.
common interpretation is that when the yield curve inverts, a recession is coming. An
inverted yield curve situation makes it difficult for the central banks to increase rates
and more likely, in fact, that rates may decrease. Such a situation becomes negative for
the dollar or any currency involved. A flat yield curve indicates uncertainty about the
economy. On December 27, 2005, the yield curve inverted for a few days for the first time
in five years. Also, there is no guarantee that an inverted yield curve will always predict
a recession, but when the yield curve inverts, the forex trader should be very vigilant.
Strategies favoring a weaker dollar or currency pair should be considered.