The slope of the yield curve has long been used as a predictor of recessions. The yield curve measures the difference between short-term interest rates and long-term bond interest rates. The slope of the yield curve generally flattens or becomes downward sloping before an economic downturn. Below is an example of an inverted (downward sloping) yield curve compared to a normal rising yield curve
Recent research published by Research Affiliates confirmed that the slope of the yield curve along with equity market returns can be used to identify turning points of the business cycle. They identified four business cycles; bull economy, correction, bear economy and rebound.
A bull economy is where the economies level of production output is above its estimated potential level, while a bear market is when its level of production is below its potential. A correction is when production in output drops and the economy slows or goes into recession. A rebound is when economic production starts to grow again after a period of reduced growth or recession. A bear market is not necessarily a recession it simply can signify a period of below-trend production.
By analysing data from April 1991 to December 2017 across 14 developed economies (including Australia) they found a consistent association between the slope of the yield curve and the business cycle stages of correction and rebound. They did not find any significant association with the slope of the yield curve and the cycle stages of Bull or Bear economies.
For example, a flat or downward sloping yield curve indicates future rising unemployment, slower real GDP and falling wages and industrial production. This is generally interpreted by investors to reduce risk. A rebound is associated with a rising yield curve and indicates rising employment, faster real GDP, increased wages and industrial production. Investors may look to increase risk.
Going one step further they also analysed the equity market. This is because the equity market provided real-time changes in equity prices that reflect investors’ expectations of future cash flows and risk. Whereas the yield curve is forward-looking.
By analysing 6-month equity returns of the same set of economies and time periods they found that the equity markets were up during rebound and bull states and down during correction and bear states.
Combining their analysis of the Yield Curve and Equity Markets, they concluded that the US, Japan and Germany are now entering a correction phase. While for Australia the yield curve and equity return data provided only a weak signal of a potential future correction. That is, the indicators are not showing any real strong evidence of a correction for Australia – yet.
Brightman, C., Mazzoleni, M., Treussard, T. (2018) Where is the Global Economy Going? Research Affiliates. www.researchaffiliates.com