The Yield Curve and Growth Forecasts

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Case: The Yield Curve and Growth Forecasts        

  29th September 2015

Course: Financial Investments

Leandra Camanda - 152415022

Luís Saias – 152415006

Manuel Costa –

Olha Pletenytska - 152415048

1. Estrella (NY Fed) is quite certain that the yield curve is a good predictor of future Economic activity. From the case, or the link to his FAQ (link given in case), answer the following questions:

1. How successful is the yield curve at predicting recessions?

The yield curve has been positively related with the economic growth expected which means that there is a positive relation between its slope and strong economic growth.  During years, from 1950 the Yield Curve predicts US recession very well apart from 1967 when the credit crunch and slowdown in production. For this reason, questions about the consistency of the prediction were taken into consideration and people became not convinced of it as the case of Brian Sack, an economist at Macroeconomic Advisers, who provided an opposite evidence of The Yield Curve predicting recessions.

1. What type of securities and what maturities are the best to use?

Treasury securities are bonds issued by the government of each country and they are known as low-risk securities. For this reason they are the best to use on Yield Curve to predict recessions avoiding significant credit risk premiums that, at least in principle, may change with maturity and over time.

Treasury securities are divided into three categories according to their lengths of maturities:

• Treasury – Bills: these have the shortest range of maturities of all government bonds at 4, 13, 26 and 52 weeks.
• Treasury - Bonds these represent the range of maturities in the treasury family, with maturity terms of 2, 3, 5, 7, 10 or more years currently available.

All of the maturities can be used on the Yield Curve but the 10-year Treasury bond and three-month Treasury bill seem to be the ones that shows better results. This can be explained due to the fact they represent rates in a very short-term and very long-term, making more viable the prediction of the market.

1. What matters most – the level of the term spread, the change in the spread, or the level of short rates?

The term spread is a difference between interest rates of different maturities that incorporates an element of expected changes in rates and is thus indicative of future changes in real activity. The highlighted point on the slope probably suggest that look at changes in leading indicators matter —rather than levels—to predict the growth of the economy. However, the level of the term spread provides the most accurate signal of approaching recession because the level of the spread already corresponds to a forward-looking expected change in interest rates.