The dramatic upward move of long-term interest rates gives me an opportunity to look back on some of the predictions made on the basis of the inversion of the yield curve, and what might be in store next.
In December of 2005, I presented the above scatter diagram, in which each diamond represents a different quarter between 1959:Q1 and 2004:Q2. The horizontal axis measures the difference between the 10-year Treasury bond yield and the average fed funds rate over the last month of the quarter. The vertical axis gives the average logarithmic growth of real GDP (quoted at an annual rate) for that quarter and each of the following 5 quarters. The positive slope of the fitted regression line reflects the historical fact that the higher is the current 10-year Treasury yield relative to the fed funds rate, the faster GDP growth you should expect over the next year and a half.
A year and a half ago, in discussing that historical relation, I wrote the following:
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.
We now have the six quarters of GDP numbers that followed that prediction, and know that average GDP growth did indeed come out below 3%– it was 2.45%, to be exact. In fact, we now have six new observations (2004:Q3 through 2005:Q4) on the yield spread along with what actually happened over the subsequent year and half. These new observations are plotted as fuchsia squares on the figure below. All of these observations turned out to fall very near to the historical regression line. Over the last year and a half, we have watched growth rates slow, just as the yield curve predicted they would.
The most bearish signal from the end-of-quarter yield spread came in 2007:Q1, when the 10-year rate stood 69 basis points below the fed funds rate. According to the historical regression, that would imply a prediction for average GDP growth between 2007:Q1 and 2008:Q2 of 2.37%.
But since then, the 10-year yield has shot back up to par with the fed funds rate. Like Menzie, Dave Altig, and Kash Mansori, I have a hard time buying the oft-repeated claim that this movement signals a surge in inflation expectations. Kash’s plot using the behavior of inflation-adjusted TIPS seems pretty convincing:
If instead you thought this move was driven by an upward revision of expectations of future real growth, according to the regression relation above, that would require that the predicted 6-quarter average real growth rate just went from 2.37% to 2.79%.
Do you believe that? Don’t know that I do. But it’s hard for me to avoid reading some increased optimism into this month’s move in long-term yields.