Tuesday, November 30, 2004

The Yield Curve, Part II

My last report contained the very basics of how an armchair economist can predict the future of the economy by using the yield curve. Now, we will get a little more in depth into the study of yield curves. I am doing these reports because I believe that, in a few months to a year, you will be wanting to know how to spot a recession coming up. The yield curve is one of the best tools to use for that endeavor.

The yield curve is a good predictor because it takes into consideration current monetary phenomenon along with future economic expectations. What's even better is that the long rates, which is the right part of the curve, are set on the open market (usually*). The Fed does have control over the short-term rates. Having the rates be set by a free market makes the numbers trustworthy and dependable. Most investors are not out to lose money just to fool someone else.

Current economic happenings set the short-term rates, such as the 3-month T-Bill rate. Investors' future expectations of the economy help set the long-term rates, such as the 10-year T-Bill.

Let's take a look at one study conducted in a finance and economics journal. The study is titled "The Yield Curve as a Predictor of U.S. Recessions" and is in the Current Issues in Economics and Finance Journal dated June of 1996. The study was conducted by Arturo Estrella and Frederic S. Mishkin for the New York Federal Reserve Bank.

They took the yield curve spread, which they determined to be the 10-year rate minus the 3-month rate, and gave each level a recession probability. For instance, a spread of 1.21 (Normal Yield Curve) equated out to a probability of 5% that there would be a recession four quarters ahead. A spread of -2.40 (Inverted Yield Curve) gave a 90% probability level. This was based on data from 1960-1995.

The paper provides the following example:

"Consider that in the third quarter of 1994, the spread averaged 2.74 percentage points. The corresponding predicted probability of recession in the third quarter of 1995 was on 0.2 percent, and indeed, a recession did not materialize. In contrast, the yield curve spread averaged -2.18 percentage points in the first quarter of 1981, implying a probability of recession of 86.5% four quarters later. As predicted, the first quarter of 1982 was in fact designated a recession quarter by the National Bureau of Economic Research."

Once the writers determined that the yield curve could in fact predict recessions, they compared it's effectiveness to other methods used by finance professionals. The other methods included the NYSE stock price index, the Commerce Department's index of leading economic indicators, and the Stock-Watson index.

Forecasting one quarter ahead, all of the indicators had some forecasting ability and the Stock-Watson index performed the best. Forecasting out over two or more quarters, the yield curve beat every one of the other recession predictors. The yield curve was the only indicator that could predict anything six quarters ahead, but was best when used to predict recessions four quarters ahead.

Again, the yield curve gets its power from the fact that it is a market driven system. The yield curve is the best way to see how investors with real money are treating capital currently and in the future. The yield curve has succesfully anticipated every downturn since 1959 (except the prediction in 1966 when the economy wasn't good, but wasn't in an actual recession). Yes, the yield curve did invert in 2000 predicting our last brief recession.

This was part II of the yield curve series. There will probably be at least one more. You really do need to know about the yield curve if you are a long-term investor (short-term investors/traders should know about the yield curve as well). One of the best ways to learn is through repetition. I will do my part of that equation and bring it up often. Do your part by reading and learning and you will be a better and wiser investor for it.

*I say "usually" because there are forces that can set a yield artificially; this usually does not occur. There is chatter that the Fed might set the long rate as well if they run out of weapons to use to keep the economy going. Be careful if/when it does.

Best Regards,

The Soothsayer of Omaha


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