Is The Yield Curve a Leading Indicator?

Lately, there's been a lot of talk about how the changing shape of the yield curve means that we're either going into a recession, not going into a recession, or have a healthy economy (take your pick). Arturo Estrella, Senior VHF of Research at the New York Fed (and all-around smart guy) that reviews the academic research on this topic. The whole piece is pretty technical (and probably not suitable for the layman), but he also provides a FAQ (Frequently Asked Questions) page with the "quick and dirty" answers. Here's a summary of the evidence from the first question on the FAQ:

Q: What Does the evidence say, in short?

A: The difference between long-term and short-term interest rates ("the slope of the yield curve" or "the term spread") has borne a consistent negative relationship with subsequent real economic activity in the United States, with a lead time of about four to six quarters. The measures of the yield curve most frequently employed are based on differences between interest rates on Treasury securities of contrasting maturities, for instance, ten years minus three months. The measures of real activity for which predictive power has been found include GNP and GDP growth, growth in consumption, investment and industrial production, and economic recessions as dated by the National Bureau of Economic Research (NBER). The specific accuracy of these predictions depends on the particular measures employed, as well as on the estimation and prediction periods. However, the results are generally statistically significant and compare favorably with other variables employed as leading indicators. For instance, models that predict real GDP growth or recessions tend to explain 30 percent or more of the variation in the measure of real activity. See astral and Hardouvelis (1991). The yield curve has predicted essentially every U.S. recession since 1950 with only one "false" signal, which preceded the credit crunch and slowdown in production in 1967. There is also evidence that the predictive relationships exist in other countries, notably Germany, Canada, and the United Kingdom.

Click here for the whole thing.

HT: Economist's View for the link.

If you like pictures instead of words or numbers, Smart Money has a little Java applet that show you the "Living Yield Curve". Click on this link for a quick explanation of the yield curve and a picture show that goes through the changes in the curve over time.