In glancing at Table 4 the last issue of the Economist (sub. req.), I was surprised that so many countries had downward sloping yield curves. Should we worry?
Out of the 33 economies listed in the print edition, 18 have 10 year interest rates lower than the 3 month rate (I count the euro area as one economy; the proportion would be higher if one counted the individual countries).
More significantly, while the US 10 year/3 month spread is now positive, that in the euro area is now negative. Figure 1 shows the spreads as cited in the Economist, using data from 10/10/06 and 10/11/07.
Figure 1: Ten year benchmark bond yield minus three month yield spreads, from Economist, Oct. 12, 2007 and Oct. 11, 2006 issues, and author’s calculations.
So back to the question of whether one should worry (about widespread recession). Referring to Table 4 in the Economist, one sees that many of the negative term premia are in emerging markets. It’s not clear that the standard arguments for why the yield curve predicts economic activity pertains to these economies (see this ECB working paper [pdf]).
On the other hand, Kozicki (1997) points out substantial predictive power for certain cases — when the level of the real short term interest rate is included and interacted with the spread.
Table 2 from Kozicki, “Predicting Real Growth and Inflation
With the Yield Spread,” Federal Reserve Bank of Kansas City Economic Review, 1997Q4.
This means there is some predictive power of term spreads. For Canada, with a positive spread, these estimates imply continued growth. Similarly for Sweden and Switzerland. For Japan, the positive spread is essentially not informative. For Australia and the UK, the negative spread suggests a slowdown.
Now, the newest development is the shift to negative of the yield curve in the euro area. This is shown in Figure 2. According the results in Kozicki’s Table 2, the negative sread bodes ill for growth, although it might be that the recent spreads are distorted by the effects of the credit crunch.
Figure 2: Ten year minus three month term premium, daily averages. For US (blue), ten year rate is constant maturity, three month rate is for T-bills in secondary market; for Euro area (red), the ten year rate is the GDP-weighted rate of on-the-run benchmark bond yield, three month rate is for interbank money rate. NBER recession dates shaded gray. Sources: St. Louis Fed FREDII; IMF, International Financial Statistics; NBER; and author’s calculations.
As I noted in a previous post, the euro yield curve matches the German yield curve, which predicted the last recession in the euro area. This means that the yield curve is signalling the same message as that provided by other indicators (e.g., September 28 Eurocoin).
The answer then to the question posed in the title is a strong “maybe”.