In economic forecasting, it's hard to beat
the yield curve

By Andrew Allentuck
Globeinvestor Magazine, June 6, 2008

As omens go, the yield curve is about as good as it gets. A line that connects interest rates paid for bonds, it starts off with what is paid on issues with terms of 30 days or less and runs to maturities of 30 years. The connect-the-dots idea is simple, but the potential uses for this data knitting are vast and powerful.

The curve is a graphic representation of many things: how governments are dealing with inflation issues, what amounts of money can be made by putting cash down for various time periods, how investors trade off their desire to have money today versus the price they demand for deferring having their money now, and how investors view the risk of capital markets.

There is a yield curve for every kind of debt. There is one for U.S. Treasury issues, another for Bank of Canada issues, one for AAA corporate bonds and another for single A bonds, double B bonds and junk bonds. The lower the quality of the bond, the more credit issues or odds of default creep in. Purists like to look at curves built on government bonds that, by definition and by the ability of nations to print their own money, have no issues of default in their native currencies.

The conventional or normal yield curve has a positive slope, that is, it rises from a low interest rate for a bond or treasury bill due in three months and runs up to a higher rate at 30 years. Monetary authorities can set interest rates at the low end. Inflationary expectations rule the long end. For example, on June 2, 90-day Canada treasury bills yielded 2.55 per cent to maturity while 30-year Canada bonds yielded 4.13 per cent.

When an economy is in good shape, the normal yield curve on government bonds shows the pure return on money without the risk of the events that can make or break stock prices. But when the curve shows higher interest costs for short-term financing than for long-term borrowing, hard times are likely ahead. That's because, as time goes on, investors see less demand for money - a sure sign of a slowing economy.

Since 1970, every time short rates have been higher than long rates - a condition called an inversion- the Standard & Poor's 500 composite and the S&P/TSX composite index (formerly the TSE 300) have had negative or flat earnings growth. The curve showed relatively high short rates before the dot-com bust in 2000. Investors who heeded these warnings could have sold off their stocks ahead of the collapse.

Those who figured that dot-com mania could endure or just vanish in what was called a "soft landing" for the economy were caught as the market tumbled. The slaughter of the innocents saw stock multiples fall. The yield curve saw long rates dropping even further below short rates as investors bought bonds as a place to park their money, causing their yields (coupon interest divided by bond price) to tumble.

The yield curve predicted the present economic malaise. In the 15 months leading up to the subprime housing that began last August, the U.S. Treasury curve was showing relatively high short-term rates. Says Anthony Crecenzi, author of the 2002 bestseller (in fixed income analysis circles, that is), The Strategic Bond Investor, "few indicators with such a stellar forecasting record have the yield curve's simplicity."

Its ability to predict economic growth or contraction 12 to 18 months ahead far exceeds the power of other analytical tools, including the analysis of far more esoteric macroeconomic indicators that track things like orders for tools that make other tools. As well, the yield curve beats folk tales about hemlines and Super Bowl winners.

"People want to find a reason for everything, so they take comfort in this kind of financial markets astrology, even though the relationships are spurious," says Chris Kresic, senior vice-president of Mackenzie Financial Corp. in Toronto and manager of about $4-billion in fixed income assets. "On the other hand, the yield curve has a strong statistical validity."

"The drawback of using the yield curve as an economic barometer is that it can be too sensitive to interest rates," says Edward Jong, senior vice-president at Mak Allen & Day Capital Partners Inc. in Toronto and portfolio manager of the FrontierAlt Opportunistic Bond Fund. "There is a saying that it has predicted more recessions than have happened, that it is too sensitive in predicting recessions, but it is really very accurate at predicting slowdowns whether they are recessions or something a little less severe. One can mince words, but it is absolutely a good leading indicator of economic activity."

To make use of the yield curve, one needs to understand its nuances, which appear in the shapes it can take.

Normal slope: Investors expect the economy to grow and, with that growth, to generate inflation. Investors expect a higher yield in the future when inflation is higher and erodes their returns on the bond. In each successive period, the central bank will have to raise interest rates a little. A progression of higher interest rates and the risks of parking money for many years as well as giving up liquidity all justify rates rising over time.

Steep slope: Characteristic of the beginning of an expansion or the period when an economy comes out of recession. The curve will be at, say, three percentage points higher at 30 years than at 90 days. The steeper any yield curve, the greater is the incentive to park money in long-term bonds and the lower is the relative cost of borrowing short.

Flat curve: Shows all terms have similar yields. It is a mixed signal in which investors cannot agree on what lies ahead for the economy. In application, it means that there is very little for the investor to gain by buying a 30-year bond rather than a 30-day bond. At most, the flat curve offers yield protection, Mr. Jong notes. There is no premium for taking on more time risk, but the investor can at least lock in a return for as much as 30 years.

Higher rates for short than long bonds, often called an inverted curve: Predicts recession or shows a market crisis. The future in which interest rates, that is, the return on money, is lower than in the present is a clear signal of bad times to come.

Today, the yield curve is getting to be more normal, indicating a recovery ahead in a year to a year and a half. That prediction seems to defy the present situation of stagnant or even declining economic growth in the United States and Canada, oil prices high enough to strangle the world economy, and the American housing market crisis and its resulting negative impact on consumer wealth and spending.

Economists who rely on examining the economy sector by sector see no relief from this malaise, but the yield curve says it will happen. Have faith: The curve is seldom wrong.

Special to The Globe and Mail