Yield Curve Inversions and Future Economic Growth

Updated April 13, 2006 Yield Curve Inversions and Future Economic Growth Campbell R. Harvey Duke University, Durham, NC USA National Bureau of Economic Research, Cambridge MA USA Cam.harvey@duke.edu +1 919.660.7768 office || +1 919.271.8156 mobile http://www.duke.edu/~charvey

Issue • Certain parts of the yield curve have inverted which means short-term rates are higher than long-term rates • Yield curve inversions were the topic of my 1986 dissertation at the University of Chicago • I developed a model based on work by Breeden (1979) that linked inversions to future economic recessions • Are we headed towards a recession?

Historical Track Record • The measure attracted significant attention in accurately forecasting the recession of July 1990-March 1991. • The measure also avoided false signals (for example, it forecasted strong growth in 1988 after the October 1987 crash and it forecasted strong growth in 1999 after the August 1998 financial crisis).

Evaluation of the Last Recession • In July 2000, the Yield Curve inverted forecasting recession to begin in June 2001. • Official NBER Peak is March 2001 (Yield Curve within one quarter accurate). • In March 2001, the Yield Curve returned to normal forecasting the end of the recession in November 2001. • On July 17, 2003 the NBER announced the official end of the recession was November 2001.

Exhibit 1

Exhibit 2

Yield Curve Inverts Before Last Six Recessions(5-year Treasury note minus 3-month Treasury bill yield-secondary) Annual GDP growth or Yield Curve % % Real annual GDP growth Yield curve Recent flattening Recession Correct Recession Correct Yield curve accurate in recent recession Recession Correct 2 Recessions Correct Data though April 11, 2006 Source: Campbell R. Harvey. Update of Harvey (1986, 1988, 1989).

Yield Curve Inverts Before Last Six Recessions(5-year Treasury note minus 3-month Treasury bill yield – constant maturity) Annual GDP growth or Yield Curve % % Real annual GDP growth Yield curve Recent flattening Recession Correct Recession Correct Yield curve accurate in recent recession Recession Correct 2 Recessions Correct Data though April 11, 2006 Source: Campbell R. Harvey. Update of Harvey (1986, 1988, 1989).

Recent Annualized One-Quarter GDP Growth (10-year and 5-year Yield Curves-secondary market) Annualized 1-quarter GDP growth Yield curve 10-year % Real annualized one-quarter GDP growth 5-year Both curves invert 2000Q3 Data though April 11, 2006

Recent Annualized One-Quarter GDP Growth (10-year and 5-year Yield Curves-constant maturity) Annualized 1-quarter GDP growth Yield curve 10-year % Real annualized one-quarter GDP growth 5-year Both curves invert 2000Q3 Data though April 2006

Current Situation • 15 consecutive Federal Funds Rate increases yet the long-term bond rate has remained relatively flat. • Why?

Current Situation • In the past, the Federal Reserve Bank had some control over long-term as well as short-term interest rates. Long-term rates could be impacted with its open market operations. • Given the dramatic increase in the size of the debt market, control is now limited to the Fed Funds rate. • The behavior of the long-term rate is a “conundrum” as Former Chairman Greenspan remarked. Obviously, in the recent Fed tightening, they were planning on the long-term rate to increase. Long-term rates did not increase over 13 hikes.

Current Situation • Fed Playing Catch Up With Short Rates. For an extended period of time, the Fed Funds rate was negative (on an inflation adjusted basis). This means that borrowing was subsidized by the government. At least 10 of the Fed rate hikes had no impact, because they were playing “catch up”. That is, they were moving the rate to where it should have been. This is why the last two hikes have had “bite”. Long rates moved up as soon as the Fed hiked.

Current Situation 2. Weaker economic growth. Consistent with my yield curve model, the lower long-term rate signals lower expected growth. The lower growth is consistent with the ISM index hovering just above 50. There are growing signs of a housing slowdown with Mortgage Applications running below 2004 levels; new home sales down, housing prices down, and homeowners with ARMs facing much higher interest rates.

Current Situation 3. Inflation perceptions. The long-term rate is a combination of expected inflation, expected real interest rates and an inflation risk factor. Long-term inflation expectations have decreased mainly due to the glut of cheap labor resulting from globalization.

Current Situation 4. Strong buying of long-term bonds by foreigners. For the past few years, strong buying by Asian central banks have pushed up the Treasury bond prices. However, there is a debate as to whether this has had a large impact on bond prices. In addition, this buying has flattened out recently. A recent Fed study estimated that the foreign buying pushed yields down by 150bp.

Current Situation 5. Hedge funds. There has been a recent increase in demand for U.S. bonds from the Caribbean area indicating hedge fund activity. With long-rates above short rates, many managers do “carry trades” (borrow short-term and buy long-term bonds hoping the relation between rates remains stable). As the term structure flattens, many of these managers increase their leverage which means more buying pressure on the long-term bonds.

Current Situation 6. Demographic forces. As the population ages, more money is allocated into fixed income and long-term bond yields may decrease. 7. Inflation risk. The long-rate rates contain expected inflation, expected real rates and an inflation risk factor. It is widely perceived that inflation risk (an unexpected episode of inflation turbulence) has decreased.

April 2006 • All three measures of core inflation (PPI, CPI, and PCE) key things that new Fed chair will follow. • Evidence of housing cooling. Question of whether it will be a soft landing or a hard landing in the housing market. • I fail to see a logic for a 16th hike in Fed Funds. Indeed, I did not see the logic for the 15th. It will take a while for these hikes to ‘work their way through the system’. Hence, you need to stop earlier or you run the risk of overshooting and destabilizing the economy.

April 2006 • Inverting the yield curve (even if it is a false signal) will likely increase disagreement among market participants because most associate inversions with bad economic news • Increased disagreement will lead to higher VIX and corporate spreads • Increased vol leads to higher costs of capital • Higher costs of capital lead to less investment, employment and ultimately a moderation in economic growth

Recession? • No inversion yet in key yield spreads calculated from constant maturity basis • With one more Fed hike, we could see an inversion • If inversion occurs, model would forecast recession beginning in Q3 2007.

Yield Curve and GDP Research Chronology • Campbell R. Harvey’s Ph.D. Thesis, University of Chicago, 1986. • Campbell R. Harvey, “The Real Term Structure and Consumption Growth,” Journal of Financial Economics, 1988 • Seven other works found at: http://www.duke.edu/~charvey/research_term_structure.htm

Yield Curve Inversions and Future Economic Growth