The Cleveland Fed, one of the 12 regional Federal Reserve Banks of the US, has, perhaps admirably, managed to find what it believes is some good news in the shape of the US yield curveIn the midst of the horrendous economic news of the last month, the yield curve might provide a slice of optimism. Though the yield curve has flattened since November, with long rates falling more than short rates, the difference between the rates remained strongly positive.
An inverted yield curve, where short-term interest rates are higher than longer-term ones, has preceded each of the last seven recessions, according to the Cleveland Fed. So a steep curve, with long-term interest rates higher than the short-term, signals a recovery.
But, don’t break out the Cristal just yet (does anyone drink that stuff any more anyway?).
Paul Krugman, rightly in our opinion, takes issue with the Cleveland Fed’s conclusion:
The reason for the historical relationship between the slope of the yield curve and the economy’s performance is that the long-term rate is, in effect, a prediction of future short-term rates. If investors expect the economy to contract, they also expect the Fed to cut rates, which tends to make the yield curve negatively sloped. If they expect the economy to expand, they expect the Fed to raise rates, making the yield curve positively sloped.
And so with the Fed’s target rate at zero per cent (and effectively dipping below that) — longer-term rates have to be higher than short-term. In other words:… the yield curve doesn’t offer any comfort. It’s only telling us what we already know: that conventional monetary policy has literally hit bottom.
The yield curve in the UK, incidentally, where official rates stand at 2 per cent, slopes downwards initially on the expectation that Britain will cut rates a la its US counterpart, then sharply moves upward. Dresdner analysts have already commented that they expect the fundamental behaviour of the yield curve to start changing amid zero per cent interest rates. Instead of bull-steepening and bear-flattening, we’re starting to see bull-flattening and bear- steepening, for the reason Krugman outlines above.
Of course the irony in all this is that back in 2006 economists were advising people to ignore the yield curve — just as it was beginning to signal something was wrong — namely a “naive belief in price stability” according to the Economist’s Free Exchange blog, as well as a massive influx of capital.
This New York Times article from January 2006, for instance, does a shockingly convincing job of playing down the curve flattening:
BUT most economists aren’t prepared to call the globally flattening yield curves – which resemble bunny hills more than ski slopes – a harbinger of slower growth.
“I don’t think that in any of these cases the shape of the yield curve suggests weakness,” said Ted Truman, senior fellow at the Institute for International Economics in Washington. “The global economy is very strong.”
Related links:
The world isn’t flat, but its yield curve may be – New York Times
The living yield curve – SmartMoney
All hail the zirp regime – FT Alphaville