Explaining the Yield Curve

Yep I know, a daunting task but I am not alone here so don't fret. I am quite sure that the end result will be informative or at least I will do my utmost to achieve this. So let us begin ... I will start with one of my previous posts over at the CBS student blog Cultunomics about the inverted yield curve (I will return to this later). Let us start with some basic links from
Wikipedia and the textbook definition of the yield curve.

(Quote from my post at Cultunomics)

But before we get ahead of ourselves, we need some theoretical clarification so that I know we are understanding each other.

The appropriate Wikipedia links are presented below.

- Yield curve
- Bond
- Inflation
- Interest rates

(...)

The textbook definition of the yield curve ...  

'The yield curve reflects the interest rates on government bonds of different maturity. Normally the curve slopes upwards which means that the interest rates (yields) on long term bonds are higher than on short term bonds (also coined as the spread). This means, quite naturally, that investors demand a higher price for holding long term securities than for holding short term securities.'

So this is basically it but more importantly economists speak of the yield curve as an indicator of the evolution of the economy and here also the idea of the inverted yield curve (when long term yields are higher than short term yields) becomes important because it is commonly said that an inverted yield curve signals a recession in the economy. So let me present some references and places to go if you want more on this ... My initial impetus for doing this round-up of the yield curve is a recent post by James Hamilton from Econbrowser about reading the yield curve. The post is excellently crafted and has spawned due attention and applause from Mark Thoma and Dave Altig (and perhaps others as well).

(From James Hamilton's post) 

What are the implications of the current shape of the yield curve?

The yield curve is often used to summarize the interest rates on Treasury instruments of different maturities, with the yield plotted on the vertical axis against the time to maturity on the horizontal axis. In normal times, if you just know the average level and slope of this curve, you could predict the yield on a bond of any specified maturity pretty well.

(...)

Note especially the idea and notion of the expectations hyporthesis and what it means.  

A starting point for any discussion about the yield curve is the expectations hypothesis of the term structure. This posits that, at any point in time, the differences in yields for different maturities are such that you can expect to earn the same total return regardless of which instrument you buy.    

You might as well start and stop with James's account but by all means lets not. Another general guide (PDF) to the yield curve comes from Arturo Estrella from the New York Fed. The paper is structured as a FAQ so it is very accesible. In terms of the yield curve's ability to predict an economic recession all my references deal with this because this is what it is all about; so can the yield curve predict a recession and what does it mean if it is inverted? A source on which is also cited many places (hat tip to Dave Altig (see link above) and Political Calculations) is a paper by Jonathan H. Wright from the Federal Reserve Board about the Yield and its ability to predict recessions.

(From Jonathan H. Wright)

'The slope of the Treasury yield curve has often been cited as a leading economic indicator, with inversion of the curve being thought of as a harbinger of a recession. In this paper, I consider a number of probit models using the yield curve to forecast recessions.'

If you want some of this a bit more condensed I can recommend this Economics Focus article from the Economist (walled for non-subscribers) which I deal extensively with in my Cultunomics post cited and linked above. The article seeks to explain what an inverted yield curve means and why it might spell a forthcoming recession. The article, which is partly based on Arturo Estrella's paper cited above, presents two possible explanations of the inverted yield curve and its implications ...

(From the Economist)

1) An inverted yield curve, then, suggests that short-term rates are higher today than they will be in the future. But why should this necessarily spell recession? Normally, it is because the Federal Reserve is in the midst of a campaign against inflation. To win this battle, short-term rates are sometimes raised high enough to induce a recession, which squeezes inflation out of the system. In due course, lower inflation will pave the way for lower short-term rates. But before this happens, long-term bond yields fall in anticipation of the future victory. In this case, an inverted yield curve is just a measure of the Fed's power.

2) Alternatively, inversions may be a measure of the Fed's ignorance. The bond market may know something the central bankers don't. Long-term rates may be subdued, because the market anticipates a recession that will eventually force the Fed to loosen monetary policy. But short-term rates remain high, because the Fed has yet to act on what the bond market foresees.

I think this should be enough, at least for framing the arguments that is. However, below I include even more references to this topic in order to give you the possibility to shop a bit around.

Additional references to explaining/understanding the Yield Curve

Mark Thoma - Why is the Yield Curve Flat?

'Is this the answer?:

Goldman Sachs Economist May Just Have THE Answer, by John M. Berry, Bloomberg: Why have long-term interest rates hardly budged in the face of 13 increases in the Federal Reserve's target for the overnight lending rate? Economist Bill Dudley of Goldman Sachs has an answer -- maybe THE answer. And if Dudley's view is correct, the flattening of the yield curve over the past 18 months isn't signaling a significant slowdown in U.S. economic growth, much less a near- term recession. Dudley's explanation ... is straightforward:'

Dave Altig 18th May 2006 - Poole (And Haubrich) On The Yield Curve

'Federal Reserve Bank of St. Louis president William Poole weighed in today on whether we should care about the spread between long-term and short-term interest rates and, if so, why?  If you are new to the topic it is a nice enough introduction, but there is also plenty there for people who have thinking about the topic for awhile.  What I found interesting was his take on why the yield curve -- yield curve "inversions" in particular -- may have been more informative back in the day:'

Greg Mankiw 12th June 2006 - What does an Inverted Yield Curve mean?  

'Q: How well does the yield curve predict upcoming economic trends?

A: Pretty well, as compared with other indicators, but it is far from perfect. Remember that economic activity is only one thing the Fed looks at when setting interest rates. It also looks at inflation. So the yield curve also reflects investors' perception of inflation trends. And economic conditions have a great deal of instrinsic uncertainty, which makes even the best indicator far from perfectly reliable.

To learn more about the ability of the yield curve to forecast economic activity, you might read this recent Fed report and this speech by the Fed chairman.'

Bloomberg Radio (WARNING; 9mb mp3) with Chief Economist at Crédit Suisse Neal Soss 

The scene is initially set by the inflation data from April but slowly and surely the discussion converges on the yield curve, its slope, and the implications. Especially, the 'theoretical moment' which centers around the expectations of future yields also touched upon by James Hamilton (see above) is interesting to listen to.