The yield curve's predictive powersThe yield curve's predictive powersLuis TorresTorres
​​​​​​​​​As the U.S. economic expansion continues into its tenth year, questions about its end have surfaced. One hot topic being discussed by the media is the yield curve.

Why is there such an infatuation with the yield curve?

Before each of t​he last seven recessions, short-term interest rates rose above long-term rates (see figure), producing what economists call an inverted yield curve (for more on this, read "Is There Still a Message in the Inverted Yield Curve?"). In the past, the yield curve has been a good indicator to ​​​​predict recessions in the U.S. economy with a one-year lead.

Last week, Charles Evans, president of the Federal Reserve Bank of Chicago, said in a speech, ”The question now is what about a flattening curve? . . . Long-term interest rates have been going down over a very long period of time. Inflation has been coming down. This is a global phenomenon. More capital has been coming to the U.S. in the sense that emerging-market economies—people around the world who are wealthier are looking for safe places to invest. . . With lower long-term interest rates, and in a rising short-term environment, you’re going to naturally get a flattening yield curve.”

This reminds me of something former Federal Reserve Chairman Ben Bernanke said in March 2006: “I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come.”

Do you see any similarities?

Was the yield curve signal noticed in 2006? Yes, but it was discounted. At that time, many studies cited reasons why the flat, then negative, yield curve did not necessarily signal a recession. Reasons included low levels of interest rates, reductions in the term premium, and positive signs from other indicators. The issue with the inverted yield curve is that its long lead time—about a year before a recession—often makes it inconsistent with other indicators. For example, while the yield curve is negative, employment is still growing.

​The good news is that the yield curve hasn’t inverted yet and the economy is still registering positive momentum going forward. Even with the arguments of foreign capital flowing into the U.S. and lower long-run inflation expectations explaining why the yield curve has been flattening, maybe this time is different. We'll be waiting to see if the yield curve turns negative.

Ten-year bond rate minus three-month bill rate image

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