The Yield Curve and Recessions

MATT BRIGIDA

Associate Professor of Finance (SUNY Polytechnic Institute) & Financial Education Advisor, Milken Institute

In this presentation we'll discuss the theoretical justification, and take a look at the historical data

The basic idea is that long term interest rates are an average of the short-term interest rates over the life of the bond.

For example, the yield on a 10-year treasury note is the average of the expected yields on 1 year notes for the next 10 years.
Since we know the 1 year rate today, the 10 year note yield affords us information about the rates over the following 9 years.

Similarly, the 10-year note rate is the average of today's 5 year note rate, and the expected 5-year note rate in 5 years.

So if today's 10-year rate is 5%, and todays 5-year rate is 2%, then the expected 5-year rate in 5 years is: 8.09%
Note this is a case of an upward sloping yield curve (the normal state of the curve).

However, what if today's 10-year rate is 5%, and todays 5-year rate is 7%?

Then the expected 5-year rate in 5 years is 3.04%
In this case we expect future interest rates to be lower than present interest rates---the yield curve is inverted.
This is consistent with slowing economic growth (and recession).

On the next slide you can enter today's 5 and 10-year rate, and see the expected 5-year rate in 5 years.

Enter 10-Year Rate (in %):
Enter 5-Year Rate (in %):

5-Year Rate in 5 Years: %

It makes theoretical sense that an inverted yield curve indicates a future recession, but does the historical record agree?

On the next slide is an interactive plot showing the difference in yield over time, and recessions shaded in pink.
The difference in yields do tend to collapse prior to a recessions, and so the historical record tends to agree.