NAVYA BEHL

215PGE031

Yield Curve as a Predictor of Recession

Introduction
Various methods are used by economists to predict the path economy of different countries like
GDP growth, unemployment rate, various econometric models etc. One such indicator is the
yield curve which is a graphical representation of interest rates of varying maturities with the
bond’s yield on the vertical axis and the time to maturity across the horizontal axis. Yield curve
is a fundamental component of financial/bond markets and has recently garnered tremendous
attention for its ability to forecast the path of economy, the likelihood of inflation or recession.
This paper delves into the relationship between the shape of the yield curve and the occurrence
of recessions, exploring the theory behind it and the empirical evidence supporting it.
Yield curves are typically upward sloping suggesting that value of the long-term bonds exceed
the value of the short-term bonds. However, deviations from this i.e., the phenomenon of the
inverted yield curve wherein the short-term rates surpass the long-term rates are associated
with economic downturns. It is observed that an inverted yield curve is generally followed by
periods of recession, which poses a question: is yield curve a reliable predictor of economic
recession?
This research aims to provide a comprehensive examination of the yield curve’s role as a
precursor to recessions. An analysis of the historical data, theoretical constructs as well as the
empirical evidence will be undertaken in this study to provide some clarity on the ongoing
debate on the usefulness and limitations of the yield curve as an indicator of economic
downturns. The subsequent sections of this paper will delve deeper in to the background,
theoretical framework, analysis of the relevant data and ultimately draw conclusions based on
the findings and implications of this investigation.

Background of the problem

The emergence of the yield curve as a potential harbinger of economic contractions dates back
to empirical observations of its behavior preceding significant downturns in the economy.
Harvey (1988) conducted an analysis in which he examined the predictive power of the yield
curve by scrutinizing historical data encompassing yield curve inversions and subsequent
recessions. His research highlighted the notable correlation between periods of yield curve
inversions and the onset of economic downturns. He looked at four different economic
downturns from the 1960s to the 1980s and established a correlation between the inverted yield
curves and the following recessions. Research from the San Francisco Fed reveals that, except
for one instance, all nine recessions post-1955 have been anticipated by an inverted yield curve,
with a timeframe ranging from six to 24 months between inversion and recession onset,
prompting immediate attention from economists and investors upon the yield curve's inversion.
(Tellez, 2023)
Harvey's contribution was instrumental in cementing the yield curve's status as a primary
indicator of economic downturns. His research uncovered the statistical relevance of yield
curve fluctuations and their potential for accurately predicting impending economic
contractions. Significant examples, including the yield curve inversion preceding the 2008
Great Recession, have sparked widespread curiosity in comprehending the forecasting
capabilities of this financial measure. The striking correlation between yield curve
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abnormalities and subsequent economic struggles has motivated scholars to delve further into
unraveling the underlying mechanisms of this association.
With the combination of economic theories, empirical evidence, and real-world applications,
the yield curve has become a highly relevant topic for both academic study and practical use
in financial decision-making. As the world economy experiences periods of growth and
downturn, the level of significance placed on comprehending the yield curve's ability to
forecast future trends rises, playing a crucial role in informing economic policies and guiding
investment approaches.

Theoretical Background
The yield curve, a visual representation of the fluctuation of interest rates for bonds with
varying due dates, holds more significance than just its role in financial markets. It acts as a
key tool for economists and analysts, providing insight into the future direction of the economy,
particularly in forecasting recessions.
Term Structure of Interest Rates
Central to understanding the yield curve's predictive power is the concept of the term structure
of interest rates. This framework reveals the connection between interest rates and the length
of time until bonds mature. In times of stable economic conditions, the term structure typically
slopes upward, indicating that long-term bonds carry higher yields than shorter-term ones. This
reflects the common belief that investors should be compensated for delaying their initial
investment, known as the "time value of money."
Some terms related to term structure of interest rates:
Spot rate: Spot rates are specific interest rates applied to particular maturities for bonds or
loans. This means that they represent the current market rate for a specific investment at a
certain point in time. For example, the spot rate for a 5-year bond reflects the interest rate for
a bond that will mature in exactly 5 years.
Present value: It is the current worth of a future sum of money or cash flow, taking into account
its discounting. This means that the present value considers the time value of money,
recognizing that money available today is typically worth more than the same amount in the
future due to its potential to earn.
Yield to maturity: YTM is the overall expected return on a bond if it is held until it matures.
This annualized rate takes into consideration all potential factors that could impact the return,
making it a useful measure for investors.
Shapes of Yields curve
The traditional yield curve typically takes on three distinct shapes: normal, flat, and inverted.
These variations from the norm indicate different market projections. A normal yield curve,
characterized by its upward slope, When the yield curve is upward sloping, it means that the
long-term interest rates are above the short-term interest rates. This indicates that the yields on
long term bonds are rising and thus leading to economic expansion, in simple words it suggests
that the investors are optimistic about the future and are willing to invest in long term bonds.
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A flat yield curve, with minimal difference between short-term and long-term rates, which
implies that the yields are same across all the maturities which gives no incentive to investors
and lenders to lend for the long term. This suggests hesitancy or uncertainty in the market,
possibly forecasting economic slowdown.
Most intriguing, if the yield curve is downward sloping/ inverted it means that the long-term
interest rates are below the short-term interest rates. This indicates that investors expect yields
on longer maturity bonds to be lower in future and thus leading to economic recession.

Expectations Hypothesis
The Expectations Hypothesis is a theoretical concept aimed at understanding the intricacies of
the yield curve. According to this hypothesis, the long-term interest rates reflect the market
participants' anticipations of future short-term rates. Therefore, adjustments in the yield curve
can be attributed to changes in expectations regarding economic conditions and monetary
policies. The behavior of the market is a crucial factor in shaping the yield curve. Investors,
who are affected by various factors such as economic indicators, central bank policies, and
overall market sentiment, make decisions about bond purchases that ultimately lead to
fluctuations in yields across different maturities. Hence, the yield curve not only represents
fundamental economic conditions but also reveals the perceptions and anticipations of the
market.
Economic Indicators and Yield Curve Dynamics
When analyzing the predictive strength of the yield curve, economists closely examine a range
of economic indicators that may impact its fluctuations. The unemployment rate, GDP growth,
inflationary forces, and central bank strategies are essential factors that influence interest rates
and ultimately shape the yield curve. The efficiency of the yield curve's predictive abilities lies
in its ability to react to changes in the economy. By studying past trends, it has been observed
that periods of yield curve inversions, where short-term rates exceed long-term rates, frequently
anticipate economic downturns. This anomaly in the yield curve has become a crucial indicator
for economists and market players, garnering significant attention.
Empirical Evidence and Historical Significance
Through empirical research, scholars like Andrew Harvey (1988) have repeatedly shown the
predictive abilities of the yield curve. By examining a statistical analysis conducted by Harvey,
it is evident that yield curve inversions have a significant correlation with recessions. These
findings add to the existing argument for the yield curve as a leading indicator. Moreover,
notable events in history, such as the yield curve inversion that preceded the 2008 Great
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Recession as well as the recession after the Covid 19 Pandemic, have only further solidified
beliefs in the yield curve's predictive accuracy. The consistent pattern of yield curve anomalies
preceding economic downturns serves as further evidence of its significance as a potential
forecaster of recessions.
In sum, the yield curve's ability to forecast economic downturns is rooted in its responsiveness
to shifts in the economy, market projections, and past patterns of economic contractions. Its
various shapes, movements, and deviations from the expected signify a dynamic interplay of
economic indicators, investor sentiments, and expectations for future economic developments.
Though not without flaws, the yield curve's rich history and theoretical foundations continue
to fascinate economists and market participants alike as a potential foreteller of economic
recessions.

Data Analysis
Firstly, by examining the yield curve data in 2007 and by plotting it on a graph we find that the
yield curve is downward sloping. Also, while comparing it to our inflation data we find that the
inverted yield curve in 2007 was in fact followed by a recession in 2009.
Here is the yield curve :

The graph for inflation rate:

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By examining both the graphs we can say that the inverted yield curve in 2007 might have
predicted the recession in 2009.
Then a correlation and regression analysis were also undertaken between the yield curve spread
of 2007 (1-year treasury bond and the 10-year treasury bond) and the corresponding monthly
inflation rate of 2009. These were the corresponding results and findings:

By analyzing the data on the 2007 monthly yield curve spread of 1-year and 10-year Treasury
bonds and the monthly inflation rate of 2009, we gained valuable insights. The correlation
coefficient of 0.507 revealed a moderate positive relationship between these two variables. This
means that as the yield curve spread shifts, we can expect a similar movement in the inflation
rate, though the connection may not be considerably strong. Essentially, a higher yield curve
spread tends to correspond with an increase in inflation, and a decrease in the spread is
correlated with a decrease in inflation. However, correlation does not imply causation, and
there could be additional factors at play affecting both variables. As we interpret these findings,
it's crucial to take into account other economic indicators and potential influences on inflation.
Furthermore, the regression analysis showed an R-squared value of 25.71%, indicating that
approximately 25.71% of the variability in the 2009 inflation rate could be accounted for by
changes in the yield curve spread from 2007. a moderate R-squared value of 25.71% warrants
careful consideration, particularly in fields where multiple factors play a role in determining
outcomes. When examining the relationship between changes in the yield curve spread from
2007 and the 2009 monthly inflation rate, a 25.71% explanatory power suggests that
approximately one quarter of the variation in inflation can be attributed to this variable. This
finding carries significance depending on the specific context of your analysis and the
importance of being able to predict or explain inflation through yield curve movements.
However, it is crucial to note that there are other factors at play in the economy and market that
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could also impact inflation rates, beyond just the yield curve. Therefore, a lower R-squared
value may indicate that there are additional variables not captured in the model that could also
have an influence on inflation.
Visual representations of the yield curve and inflation rate over time provided a clear
understanding of their trends, highlighting fluctuations and potential patterns. However, it
should be noted that although the analysis resulted in a moderate correlation and a modest
explanatory power of the yield curve, it was still a valuable indicator of the relationship
between these variables. It is crucial to acknowledge potential limitations, such as the influence
of other economic factors not included in the model.
Huseyin Ozturk and Luis Felipe V.N. Pereira in their study of Yield curve as a predictor of
recessions empirically test whether the slope of the yield curve is a good predictor of recession.
After analyzing the panel data from 32 countries they found out that recession is correctly
predicted 63% of the time even for countries with short time series. The panel data estimation
also suggested goodness of fit. (Ozturk and Pereira, 2013)
Another paper by Arturo Estrella and Frederic S Mishkin named ‘The Yield curve as a predictor
of recessions in the United States and Europe’ is helpful in our analysis wherein they undertook
a probit model for the US recession probability using the yield curve spread. The paper quotes
that ‘The results obtained from a model using the yield curve spread are encouraging and
suggest that the yield curve spread can have a useful role in macroeconomic prediction,
particularly with longer lead times. Because forecasters and policymakers care more about
longer term forecasts, the fact that the yield curve strongly outperforms other variables at longer
forecasting horizons makes its use as a tool in the forecaster's toolbox even more compelling’.
(Estrella and Mishkin,1996, Pg. 334)
The research conducted by Mohamad Shaaf using the Artificial Intelligence Model also gave
similar results as our findings till now. He also concluded that after using the data from 1958
and 1997 the findings aligned with the earlier econometric studies that a flat or downward
sloping curve is a reliable predictor of recession even with the use of a more advanced and
accurate AI model which generates less errors and lower variation than the regression model.
(Shaaf, 2000).

Arguments Against Yield Curve as a Reliable predictor

Economists and analysts have started questioning if yield curve is still and accurate predictor
of recession. They claim that yield curve could be inverted due to a variety of reasons. Various
new perspectives have come into light:
An alternative perspective given by JP Morgan states that instead of signaling a recession, the
higher yields on long-term bonds could be anticipating a significant drop in inflation. This
scenario implies the possibility of the Federal Reserve halting its interest rate hikes, and
potentially even considering rate cuts in the near future.
Another given by Goldman Sachs that investors seem to be anticipating a shift back to the
slow-growth conditions seen before the COVID era, rather than expecting a sudden decrease
in inflation. (Philips, 2023)
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Conclusion
The research paper delved deeply into the intricate and fascinating connection between the
yield curve and its ability to predict economic recessions. Using a theoretical framework, the
paper explored key concepts such as the term structure of interest rates, various shapes of the
yield curve, the expectations hypothesis, and the historical significance of the yield curve in
anticipating recessions. Supported by compelling data, including the notable analysis of
Harvey, Ozturk and Pereira, Estrella and Mishkin, Shaaf reinforced the premise that yield curve
inversions, often signal impending economic downturns. However, an examination of the
specific relationship between the monthly yield curve spread of 2007 and the monthly inflation
rate of 2009 showed a moderate yet meaningful positive correlation and a modest level of
explanatory power.
The study revealed a correlation between changes in the yield curve spread and inflation rate,
however, it is crucial to acknowledge the study's limitations. Economic indicators affecting
inflation can be complex, and there is a possibility of omitted variable bias. Moreover, the ever-
changing nature of financial markets highlights the need for extensive analysis. In summary,
while the yield curve shows promise as a potential predictor of economic recessions, its
effectiveness can be improved by incorporating other economic variables and utilizing more
advanced models. Future research should concentrate on refining models, considering a wider
range of economic factors, and exploring nonlinear connections to enhance our understanding
of the yield curve's role in forecasting economic downturns.
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References
 Ozturk, H., Pereira, L. F. V. N. (2013). Yield Curve as a Predictor of Recessions:
Evidence from Panel Data. Emerging Markets Finance & Trade, Vol. 49, Supplement
5: Structural Issues and Transition in Emerging Markets (November-December 2013),
pp. 194-212 (19 pages)
 Estrella, A., & Mishkin, F. S. (1996). The yield curve as a predictor of recessions in the
United States and Europe, Quarterly Economic Journal.
 Tellez, A. (2023). What To Know About the Yield Curve—And Why It May Predict a
Recession.
 Shaaf, M. (2000). Predicting Recession Using the Yield Curve: An Artificial
Intelligence and Econometric Comparison. Eastern Economic Journal, Volume (26), Pg
171-190.
 Phillips, M. (2023). The yield curve may be wrong when it comes to predicting
recession.