EconSouth (First Quarter 2007)
Volume 9, Number 1
First Quarter 2007
Fed @ Issue
|Paula Tkac is a financial economist and associate policy adviser in the Atlanta Fed's research department.||Should We Worry About the Inverted Yield Curve?|
For the better part of the past year, we've been living in an era of the inverted yield curve. This economic state of affairs is fairly uncommon, having occurred only seven times since 1952; the most recent inversion before the current one occurred in 2000, just prior to the last recession. Is this rare phenomenon a cause for concern, a portent of slower growth or even recession?
Articles in the popular media might lead us to believe the answer to this question is a resounding "yes." But a more thorough analysis leads to a different conclusion: There seems to be little reason right now to be overly concerned about what's happening with the yield curve.
Yield Curve 101
To understand the issue, we need to look inside the yield curve and the forces that drive its shape. "Yield" is the return from holding a security to maturity. The yield curve is merely a name for the relation between the yields on U.S. government Treasury securities with various terms to maturity (for this reason, it is also called the term structure of interest rates). A common statistic used to describe the shape of the yield curve is the difference (spread) between the yield on a 10-year Treasury bond and a three-month Treasury bill. A positive spread occurs when the 10-year bond has a higher yield than the three-month bill. In contrast, an inversion occurs when the spread turns negative—that is, the 10-year bond's yield is lower than the three-month bill's. The chart illustrates the current inverted yield curve, from earlier this year, and a more common upward-sloping yield curve, from late 2005.
Five of the last six episodes of yield curve inversion have been followed by an economic recession; this observation has led market observers and some academic researchers to contend that an inverted yield curve is a powerful predictor of an impending recession. But this simple correlation masks a much more complicated relationship between yields in the bond market and forecasts of real economic activity.
Expectations bend the curve
Sophisticated financial investors and institutions trade U.S. Treasury securities in a free and open market. Their trades reflect their expectations about monetary policy actions by the Federal Open Market Committee (FOMC) and, indirectly, expectations regarding inflation, real interest rates, and gross domestic product growth. Thus, the yield curve reflects aggregate market expectations about a range of economic variables. A forecast for recession could drive long-term yields lower if traders expect the FOMC to respond with lower short-term rates. However, there are other potential explanations as well.
Indeed, expectations about inflation—and, more directly, monetary policy actions to control it—are likely the driving force behind the current inverted yield curve. The credibility of the FOMC to keep inflation low acts to decrease the additional yield, or risk premium, that investors typically demand to hold longer-term securities. Investing in these securities is less risky if a low path of future inflation is more certain and if a major inflationary episode is less likely to occur. Thus, the market's belief that the FOMC will keep inflation under control acts to flatten, or level, the yield curve. A market expectation that short-term interest rates will edge lower can push further to actually invert the yield curve.
|The Yield Curve|
According to the 10-year-three-month spread, the yield curve has been inverted since July 2006. But the largest inversion occurred on Dec. 6, 2006, with a spread of -60 basis points (or -0.6 percent; a basis point is a hundredth of 1 percent). At that time, financial markets expected the FOMC to lower the target rate for fed funds in the coming six months, from 5.25 percent to 5 percent.
As of mid-February, market expectations have changed, and by early March investors believed that the FOMC will leave the rate target at 5.25 percent through July 2007. Consistent with this view, the yield curve has both risen overall and become less inverted. The yield on three-month bills increased 11 basis points while the 10-year bond yield rose 47 basis points, narrowing the spread to -24 basis points. The increase in the expected fed funds target rate influenced bond market traders to revise their expectation of future longer-term interest rates.
Wait and see
In the past, an inverted yield curve has most often been followed by a recession within four quarters. At this point, though, a reasonable conclusion is that the inverted yield curve is reflecting anchored expectations of low inflation, forecasts of lower interest rates, and faith in the FOMC's ability to make the right decisions to achieve these outcomes.