The yield curve plots the interest rate paid on different Treasury securities as a function of the number of years until the security matures. Usually investors require a higher yield on longer-term assets, so that the yield curve slopes up, as it did a year ago. As of a month ago, the extra yield on 10-year over 1-year bonds had all but disappeared, and this week the 10-year rate at times actually slipped below the 1-year rate, creating an inversion of the usual upward slope over at least part of the yield curve.
Why did this happen? The short rate has been rising rapidly because the Federal Reserve is concerned about inflation and has been raising rates to slow the economy. The longer term yields fell this month because investors’ expectations of both inflation and the level of economic activity likely slipped a bit, along with a possible decline in the term premium. All of these factors usually suggest the likelihood of a slowdown in economic activity.
One way this is often summarized is by looking at the spread between interest rates of two different maturities. For example, the graph on the left summarizes the implications of the spread between the 10-year Treasury and the overnight fed funds rate. Each quarter between 1959:I and 2004:II is represented by a separate diamond on this scatter diagram. The horizontal coordinates correspond to the yield on a 10-year Treasury security minus that for an overnight fed funds loan during an average day of the last month of that quarter. The vertical coordinate corresponds to the average logarithmic growth rate of real GDP over the six quarters beginning with that quarter, quoted at an annual rate. The positive correlation represents the fact that the lower the gap between 10-year yields and the fed funds rate, the slower average growth we’ve usually observed for the economy over the next year and a half. The indicated regression line summarizes this tendency– the regression coefficient of 0.6 means that for every 100 basis point decline in the spread there is on average a 60 basis point decline in average growth rates.
The first thing to emphasize about this relationship is that it’s not a sure thing. For example, in 1995:IV the spread was near its current low level of 11 basis points, and yet we saw 3.9% average growth between 1995:IV and 1997:I. In 1965:I and 1965:II the spread was 17 basis points, only a little higher than its current value, and the economy boomed at a 6-7% growth rate. Instead, the correlation summarizes an average or typical tendency– in 84% of the quarters in which we saw a spread as low as its current value or lower, subsequent growth came in slower than the historical 3.3% average.
A second point worth emphasizing (which I also discussed at length here) is that this is not something that only matters when the yield curve completely inverts or the spread becomes negative. Rather, the scatter diagram above suggests a gradual concern– the narrower the gap between long- and short-term rates, the slower growth we can usually expect to see.
With the 10-year rate currently at 4.38% and fed funds at 4.25%, the spread 0.13% is 73 basis points below its historical average of 0.86%. The regression above suggests that this would typically mean growth that is 0.44% slower than average, or under 3% annual growth for the next year and a half.
So how exactly might these concerns show up? Well, for example, Bloomberg reports today:
Sales of existing homes fell to an eight-month low in November, leaving the number of houses on the market at the highest since 1986 and suggesting one pillar of the U.S. economy will weaken next year.