Did They Separate? Yield Spreads and GDP

In the past, many have believed that yield spreads between investment instruments have predictive power for economic growth. In fact, economic research has shown that changes in the yield curve have accurately predicted the past seven recessions. However, has the link between the yield curve and economic growth changed behavior since the past recession? If so, how has the relationship between the yield curve and GDP growth changed? Answers to these questions could deliver very important indicators for decision makers, particularly in the financial sector, as they attempt to make educated decisions in the current environment that may be biased when based on prior-conventional economic patterns.

The U.S. Treasury Department issues investment instruments in the form of bills, notes and bonds. The maturity of these instruments varies from one month to thirty years, where a “short-term” instrument typically has a maturity of less than one year and a “long-term” instrument has a maturity longer than one year. Interest rates on these bonds also vary, where typically bonds with longer maturities have higher interest rates. A yield spread is the difference in yield (or interest earned) between two investment instruments. Moreover, the spread between the 10-year Treasury and the Fed Funds rate is a component of the Leading Economic Indicators Index, provided by the Conference Board. The U.S. Treasury yield curve represents different Treasury instruments by maturity and their corresponding yields and typically has a positive slope, as exemplified by the 2013-2014 period.

A positive yield curve shows that longer-term bonds are associated with higher yields, as investors buying the debt substitute higher returns (in the form of interest payments) in exchange for lending money and assuming risk for a longer period of time. A negative yield curve (when the short-term yield is higher than longer term yield) is called an inverted yield curve (Figure 2). In the past, an inverted yield curve has been thought to be a good predictor of recessions.3 The reasoning behind this is that as short-term yields rise above long-term yields, it is implied that investors consider short-term investments to be of higher risk than long-term investments. As a result, investors want a higher return for assuming more risk in the short run and would be less willing to lend at lower rates for longer periods.

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