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Is the yield curve signalling an impending recession?
Dr Frank Shostak
Many economists are of the view that the relationship between interest rates and the term to maturity of identical fixed income securities (also known as the yield curve) is a good predictor of economic activity. Consequently the recent inversion of the yield curve raised the alarm that US economy might be heading for difficult times. Historically most post-1950s recessions in the US were preceded by a significant declines in the differential or the interest rate spread between the 30-year T-bond and the 3 month treasury security. Typically this narrowing in the spread occurs many months before the onset of the recession. What is the reason for this predictive capability of the yield curve?
The most popular explanation of the causes that determine the shape of the yield curve is provided by the expectation theory (ET). The key to the shape of the yield curve is that long-term interest rates are the average of expected future short-term rates. Thus if today’s one year rate is 4 per cent and next year one year is expected to be 5 per cent, then the two-year rate today should be 4.5 per cent (4+5)/2 = 4.5.
It follows then that expectations for rises in short-term rates will make the yield upward sloping, for the long-term rates will be proportionately higher than the short-term rates. Conversely expectations for a decline in short-term rates will result in the downward sloping yield curve, for the long-term rates will be proportionately lower than the short term rates. Typically, it is held by the ET practitioners, an economic expansion is associated with rising interest rates and positive sloped yield curve. Thus whenever investors expect economic expansion they also expect rising interest rates. This prompts investors to move their money to short term securities thereby bidding prices up and yields down.
Since money is shifted from long term to short term securities this will depress the prices of long term securities and raise their yields. Conversely an economic slump is associated with falling interest rates. Therefore, whenever investors expect an economic slowdown or a recession they will shift their money from short-term securities towards long- term bonds. This shift raises short-term rates and lowers long-term rates i.e., an inverted yield curve is emerging, but does it all make any sense?
In his writings Murray Rothbard argued that in a free unhampered market economy an upward sloping yield curve cannot be sustained for it will set an arbitrage movement from short maturities to long maturities. This will lift short-term interest rates and lower long term-interest rates i.e. resulting in the tendency towards a uniform interest rate throughout the time structure.
Arbitrage will also prevent the sustainability of an inverted yield curve by shifting funds from long maturities to short maturities thereby flattening the curve. Similarly, Ludwig von Mises concluded that in a free unhampered market economy the natural tendency of the shape of the yield curve is not towards an upward slope neither towards a downward slope but rather towards flattening. On this Mises wrote,
“The activities of the entrepreneurs tend toward the establishment of a uniform rate of originary interest in the whole market economy. If there turns up in one sector of the market a margin between the prices of present goods and those of future goods which deviates from the margin prevailing on other sectors, a trend toward equalisation is brought about by the striving of businessmen to enter those sectors in which this margin is higher and to avoid those in which it is lower. The final rate of originary interest is the same in all parts of the market of the evenly rotating economy”.
Another theory called the Liquidity preference theory (LPT) seems to have a better reasoning for the upward sloping yield curve. According to the LPT people demand a risk premium for longer maturities over the short-term maturities. Thus the longer the maturity the higher the risk of not getting back the initial outlay. Also, there is the risk associated with the rise in interest rates, which will hurt more long- term investments. The LPT however, cannot explain the reason for the emergence of an inverted yield curve.
The main problem with both the ET and LPT frameworks is that they only deal with interest rates in financial markets. However, the fundamental or basic interest rate is the natural interest rate, which mirrors peoples demand and supply of savings i.e. individuals time preferences. In short, interest rates in financial markets do not have a “life of their own” they are supported by the natural rate.
It seems therefore that a prolonged upward or downward sloping yield curve cannot be part and parcel of a free unhampered market economy. If this is the case then what is the mechanism that generates this? Both Mises and Rothbard have concluded that this must be the result of the central bank tampering with financial markets by means of monetary policies.
In a free unhampered market economy interest rates mirror consumers’ preferences. In this capacity they guide businesses in the most profitable allocation of funding. By responding to interest rates, businesses are, in fact, abiding by consumers’ instructions. However, once interest rates in financial markets are lowered artificially, they cease to reflect consumers’ preferences. This in turn means that businesses, by reacting to interest rates in financial markets and embarking on investments in long term capital projects, are committing errors, in other words, making investment decisions that go against consumers’ wishes.
While the Fed has an absolute control over short-term interest rates via the federal funds rate, it has less control over the longer-term rates. It is this that gives rise to an upward or a downward sloping yield curves. The Fed’s monetary policies disrupt the natural tendency towards uniformity of interest rates along the time structure. This disruption leads to the deviation of short-term rates from the natural rate i.e. from individuals time preferences.
The artificial lowering of short-term interest rates by the FED generates profitable opportunities that prompt investors to borrow money at lower short-term interest rates and investing in higher yielding longer-term investments. To sustain the positive sloped yield curve the FED must persist with its easy stance. Should the central bank cease with its monetary pumping the shape of the yield curve will tend to flatten and profits from “playing” the yield curve will disappear.
As long as the pace of the monetary pumping is growing and the consequent artificial lowering of short term rates remains in force, there is no way for businessmen to know that they are committing errors. On the contrary, as the loose monetary policy intensifies, it generates apparent profits and a sense of prosperity. The longer the period of loose monetary policy, the more widespread will be the errors. All this leads to a situation where entrepreneurs are committing themselves to unprofitable businesses, which ultimately must be liquidated. It is this liquidation that is called an economic bust or recession.
As a rule what triggers the bust is the central bank reversal of its loose monetary stance. The central bank slows down the monetary pumping and lifts the short-term interest rates. This in turn leads to the flattening or inversion of the yield curve. In order to sustain this inversion the FED must maintain its tighter stance. For should the FED abandon the tighter stance the tendency for rates equalisation will flatten the curve.
Contrary to the mainstream thinking as depicted by the ET, the Mises-Rothbard (MR) framework attributes the predictive capabilities of the yield curve to central bank monetary policies. In short, an upward or a downward sloping yield curve is the product of the central bank policies. To the extent that investors are forming expectations regarding future course of monetary policy this only tends to reinforce the shape of the curve as set by the central bank.
Thus when in the late stages of an economic expansion investors begin to anticipate a tighter monetary stance this tends to reinforce the upward slope of the yield curve. For investors shifting their money away from long term-securities towards short-term securities. This lifts long-term rates and lowers short- term rates. Conversely during an economic slump, brought about by the tighter central bank monetary policy, once investors have started to anticipate an easier monetary stance the downward slope of the yield curve is reinforced.
This means that the shift in the shape of the yield curve is set by the central banks monetary policies and not by investors’ expectations. At the best expectations could either reinforce or moderate the slope of the yield curve.
Whenever the central bank reverses its monetary stance and thus alters the shape of the yield curve it sets in motion either economic boom or an economic bust. Once either boom or bust is activated they do not assert their importance immediately. The reason for this is the fact that the effect of a change in monetary policy shifts gradually from one market to another market, from one individual to another individual. It is this gradual increase in the effect of a change in the monetary policy that makes the change in the shape of the yield curve a good predictive tool.
For instance when during an economic expansion the central bank raises its interest rates and flattens the yield curve, the effect is minimal for economic activity is still dominated by the previous easy monetary stance. It is only later on, once the tighter stance begins to dominate, that economic activity begins to weaken.
Contrary to mainstream thinking, as presented by the ET, the inversion in the shape of the yield curve should be regarded as an indication that short-term interest rates will rise. This in turn should be viewed as bearish for the long-term bond market and also bearish for economic activity.
The conclusion we have reached runs contrary to the ET, which maintains that a downward sloping yield curve occurs in response to expectations that short-term interest rates will fall. Conversely an upward sloping yield curve should be interpreted as pointing to lower short-term interest rates and therefore bullish for long-term bonds and economic activity. Again, this conclusion contradicts mainstream thinking, which regards an upwardly sloping yield curve in response to expectations that short-term interest rates will increase.
Finally it seems to us that most studies that extract information about future prospects of the economy from the shape of the yield curve, by means of a statistical torture of the data, are a waste of time. All that one requires in order to establish the future direction of economic fluctuations is to pay attention to the FED’s monetary policy.
Dr Shostak is a former professor of economics who now works in the private sector.
BrookesNews.Com
Monday 12 March 2007