The Use of the Yield Curve as a Leading Indicator

There has been much discussion of using the yield curve as a leading indicator. Arturo Estrella, Senior Vice President in the Research and Statistics Group at the Federal Reserve Bank of New York, reviews the evidence on the use of the yield curve as a leading indicator. The links are to the NY Fed site:

The Yield Curve as a Leading Indicator, by Arturo Estrella, NY Fed: A broad literature originating in the late 1980s documents the empirical regularity that the slope of the yield curve is a reliable predictor of future real economic activity. Today, there exists a substantial body of evidence from which various useful stylized facts have emerged. This catalogue of some of the salient findings takes the form of answers to frequently asked questions. An extensive bibliography is also included. [FAQ Available in PDF] [Bibliography]

Frequently Asked Questions: Click on a question from the following list to go to the corresponding answer.

• What does the evidence say, in short?
• How and when were the relationships first identified?
• How long have these relationships existed, and do they still hold?
• Are formal models needed to extract the information content in the yield curve, or are there also rules of thumb?
• What statistical models have been formulated?
• Which interest rates to use: Treasuries, fed funds, Eurodollar, swap, corporate?
• What maturity combinations work best?
• Is it the level or the change in the spread that matters?
• Does it matter if changes are driven by the short or the long end?
• Is an inversion required for a signal?
• Does the signal have to be persistent?
• Is the evidence robust over time?
• How do binary models that predict recessions compare with models that forecast continuous dependent variables (e.g., real GDP, industrial production growth)?
• How does the yield curve compare with other indicators?
• How does the yield curve perform out of sample, and can it be supplemented with other indicators?
• How are predictions related to monetary policy?
• How are predictions related to market expectations of the economy?
• Is there causality from economic activity to the yield curve?
• Should we expect the predictive power of the term spread for real activity to persist?

Comments

[anne]

Nice :) Then turn this fine discussion to an even more practical side for investors. A superb bull market in bonds began in 1982 and extended to this year. Investors who held long term bonds with call protection, or Vanguard long term bond funds had superb returns between interest rates and capital gains. But, interest rates reached levels so low that not only should investors have resigned to low levels of interest income but the chance of capital gains was nill. This means that at least through the Federal Reserve tightening sequence, Vanguard long term bond funds or bonds have become relatively less attractive than at any time since 1982. The problem then for investors is how to allocate a portfolio through this period?

[anne]

A terrific economics writer for the New York Times has an article that I think should have been better attended to:

http://www.nytimes.com/2005/10/23/weekinreview/23uchi.html?ex=1287720000&en=6032fcd106abbd75&ei=5090&partner=rssuserland&emc=rss

October 23, 2005

For Blacks, a Dream in Decline
By LOUIS UCHITELLE

THE Rev. Dr. Martin Luther King Jr. set forth the goal. Civil rights and union membership were to be intertwined. The labor movement, Dr. King wrote in 1958, "must concentrate its powerful forces on bringing economic emancipation to white and Negro by organizing them together in social equality."

That happened in the 1960's and 1970's. But then unions lost bargaining power and members. And while labor leaders called attention to the overall decline, few took notice that blacks were losing much more ground than whites....

[anne]

Darn, Louis Uchitelle has indeed written an important but discouraging article:

http://www.nytimes.com/2005/10/23/weekinreview/23uchi.html?ex=1287720000&en=6032fcd106abbd75&ei=5090&partner=rssuserland&emc=rss

...Despite a growing economy, the number of African-Americans in unions has fallen by 14.4 percent since 2000, while white membership is down 5.4 percent.

For a while in the 1980's, one out of every four black workers was a union member; now it is closer to one in seven. This loss of better-paying jobs helps to explain why blacks are doing worse than any other group in the current recovery. Labor leaders have acknowledged the disproportionate damage to African-Americans, but they decline to make special efforts to organize blacks and offset the decrease, saying that all groups need help. That lack of priority angers one prominent black scholar.

"The future of black workers is very bleak indeed if they lose their place in the union movement," said William Julius Wilson, a professor of sociology and social policy at Harvard. "I would hope there would be an effort on the part of union leaders, white and black, to address this very important issue. They haven't done so as yet."

The decline was particularly sharp last year. Overall union membership fell by 304,000, and blacks accounted for 55 percent of that drop, the Bureau of Labor Statistics reports, even though whites outnumber blacks six to one in unions (12.4 million to 2.1 million). The trend seems likely to continue and perhaps accelerate as General Motors and its principal parts supplier, Delphi, cut costs in their struggle to be profitable.

"We have lost 20,000 members since the end of 2000 in Detroit and its suburbs alone," said Linda Ewing, director of research for the United Auto Workers, "and a large number of the workers in the auto and parts plants in this area are black."

Unions, like other institutions in the post-World War II economy, were slow to admit African-Americans to the club, and there is still resistance today in some of the higher-paying skilled trades. Yet blacks came to rely on unions even more than working class whites did to gain entry into the middle class, through jobs that gave them annual wage increases and company-paid health insurance and pensions. Even now, the percentage of black workers who are in unions is slightly greater than the percentage of unionized white workers: 15.1 versus 12.2. "Every survey shows that blacks are the group that most wants to be unionized," said Richard Freeman, a Harvard labor economist....

[anne]

Digressing again, Mark Thoma has an abiding interest in environmental protection, and I have been startled at what appears an incessant erosion of legislative and administrative environmental safeguards:

http://www.nytimes.com/2005/10/30/opinion/30sun1.html

October 30, 2005

Pombo Time

Richard Pombo has had a hard time keeping himself out of the news lately. In late September, a watchdog group called Citizens for Responsibility and Ethics in Washington named Mr. Pombo, a seven-term House member from California, one of the 13 most corrupt politicians in Congress. Three weeks later the Center for Public Integrity accused him of taking junkets paid for by the International Foundation for the Conservation of Natural Resources - the kind of organization, heavy with corporate donors, in which the word "conservation" is a wink to the wise. And last week the League of Conservation Voters accused him of selling out to a long list of corporate interests.

But what has really put Mr. Pombo on everyone's radar is the steady stream of environmentally destructive legislation flowing from the House Resources Committee, which he runs. The legislation would undermine environmental safeguards and raise broad new threats to endangered species and public lands.

Mr. Pombo, of course, makes no apologies....

[Bruce Webb]

Let me throw out a question, one I have posed before but really have gotten little response to.

I would suspect that a large majority of Americans, even a large majority of Americans who are relatively informed on economic numbers and markets, still accept that Trust Fund shortfall will begin in 2017. That is in terms relevant to this thread, the Social Security Trust Fund will in effect become a net seller of bonds in that year. Or more rigorously that along side of whatever bond sales the Treasury is making to fund the General Fund, it will also be issuing bonds to cover partial interest payments into the Trust Fund to cover the gap between income and cost. This event is only a dozen years away and to one degree or another has to be priced into the long bond, consciously or not.

Now I have argued long and loud about reasons this event is not likely to occur in 2017 and might not even happen in 2023 when Low Cost projects a much narrower gap to appear. But leaving the specificities of the various projections aside for the moment, what would be the impact on the bond market and the yield curve if market sentiment changed overnight? What if tomorrow morning America and more particularly the American bond investor woke up and said "Shoot, Social Security is not going broke! Any dang fool who looks at the numbers knows that!" Or more soberly, what if the market had to price in Social Security being a net buyer of bonds from at least 2017 to 2023 and perhaps forever?

For the moment lets ignore interest and look at actual dollars flowing to and from the Trust Fund. OASDI and HI Annual Income Excluding Interest. Under Intermediate Cost in 2015 the Treasury will have to be selling $7 billion in public debt to cover the cash shortfall. In that same year Low Cost would have Social Security lending the Treasury $132 billion. If I am buying a ten year bond tomorrow, whether I know it or not I am looking at a $140 billion dollar gap in bond supplies at maturity of my bond. By 2020 the gap is $250 billion, either Treasury will be selling $200 billion to cover the gap (Intermediate) or still taking in $50 billion (Low Cost).

We are not talking 75 year window here, we are looking at some effects that are going to kick in very soon. The projected income/cost difference between Intermediate Cost and Low Cost for 2005 was $6 billion dollars. That is a fleabite to the bond market. By 2010 we are talking a difference of $58 billion. Now you start talking some serious scratch, and consequent market impact.

There has been a lot of talk about the stubborness of the yield curve. Well clearly we are talking about a $58 billion dollar investment that either will or will not hit the bond market in 2010 depending on how you bet on Low Cost. Is that enough to explain the stubborness? Could it be that the Chinese Central Bank is counting on $58 billion dollars less in supply in 2010 when it continues to snap up Treasuries this year? Because it would be a strange irony to find out that the smart money in China and Japan was making a huge bet on American productivity, and pulling for America.

[anne]

There is a danger, that puzzles me. Selected Senators seem willing to try to cut Medicare. John McCain startled me by suggesting that the Medicare drug benefit be set aside to control government spending after additions for Gulf Coast construction. Fortunately the House is not going after Medicare, for Representatives Medicaid cuts are the objective.

Could Medicare be vulnerable along with Medicaid? I do not think so, but....

[Mark Thoma]

Bruce - Headed out the door, but here is a very simple and quick "textbook" answer assuming all else really is equal and that conundrums do not exist. Maybe others can add more detail.

If investors expect a fall in the supply of bonds in the future because SS becomes increasingly solvent (and do not expect other government spending to increase to make up the difference), the expected future price of bonds would increase making bonds more attractive today (e.g. buy today and sell later at what is now a higher expected price). The increase in demand would raise that price of bonds today and lower today’s returns.

Do others agree? I know some of you do this stuff for a living. What else should Bruce know that I have left out?

[Bruce Webb]

Thanks Mark, that accords with my back of the envelope calculation. Somebody, somewhere is still willing to buy the long bond even as the Fed pushes the short term rate up 11 or 12 times in a row. And not demanding any more return than before.

You can go a certain distance believing that the Japanese and Chinese Central Banks regard the US as a customer "too big to fail" and so are willing to shell out some big bucks to keep their biggest customer afloat. But hey the market is the market and the fundamental principle of the marketplace is "what is in it for me?" (BTW that is a good thing - If I give you $2 for that macrame wall hanging and I walk away going 'score!' and you go away thinking 'I would have paid money to take that to the dump' we both win). There are some folks out there that are surprised that foreign investors keep buying the long bond even while conventional appraisals of the trade deficit and the current account deficit suggest that said bond sales are unsustainable. But what if the Bank of China's math is right and American financial punditocracy wrong?

I suspect the subscription base for the Cato Journal in China is pretty low. And I doubt that official publishers are going out of their way to make the novels of Ayn Rand widely available to the masses. Plus I suspect that the papers of Milton Friedman are not the first reading stop for Chinese economists.

UC Berkeley Econ Prof George Akerlof won a Nobel Prize in Economics Go Bears, de-beak the Ducks for realizing and explaining that markets as often as not work on asymmetric information, that Adam Smith's "Invisible Hand" generally has a huge pinky ring that weighs in on the market scale.

I just suggest that there is a huge ideological thumb on the scales here. Americans by and large have bought into a narrative that makes them believe that the supply of bonds going forward is unlimited, that the combination of Social Security "crisis" and General Fund deficits means the Treasury will be going cap in hand to the world financial markets forever, and hence having to pony up more to get them to loan us the money.

But what if that wasn't true?

[Bruce Webb]

Anne, the Medicare drug benefit as presently established is a travesty and putting it aside for a year or two would not necessarily be a bad thing. As is it is just a huge payout to Big Pharma. But the principle is important, the omission of drug coverage from Medicare in light of the advances in pharmacology was heartbreakingly stupid. "No we won't pay $2 a day to buy your meds but we will pay $700 a day to put you in a nursing home because you didn't take them". The nose of the camel is under the tent, some future Congress and some future President will realize that we can use the leverage of Medicare to reduce profit returns of Big Pharma down to the rest of industry, or considering how much the government underwrites basic drug research, even less. Bush put us on the path to single-payer. He didn't mean to but the economics will drive it.

[anne]

Absolutely not. Though I do agree with your thoughtfilled criticisms, I am too worried about loss of any Medicare benefit to wish for more than an adjustment to the drug coverage provisions. That the coverage finally came is remarkable, and I completely approve making the provisions increasingly manageable but not cutting benefits. Drug therapy is just too critical a part of health care to step back now. Then wrestle over provisions.