How bonds perform in the market is a good way to understand how the economy is doing. However, it may be true that the current performance of bonds reflects investors’ expectations for the future and how the economy will perform in the next six to twelve months. In this way, the bond market is considered a leading indicator.
The Yield Curve as a Predictor of the Economy
Based on this background, the best way to use bonds to predict the economy is to look at the yield curve. The yield is the return or income that an investor will receive from buying and holding the bond.
The “yield curve” simply consists of bonds with varying maturities from one month to 30 years. The bonds are plotted on a graph based on their yields. The curve typically slopes upward, as investors demand higher yields for holding long-term bonds.
Since the yields of bonds of all maturities change daily due to market fluctuations, the “shape” of the curve is always changing. From these changes, insights can be gained about economic outlooks.
Long and Short Spread in the Yield Curve
Short-term bonds are those that mature in two years or less from the date of purchase. Their performance is primarily determined by expectations regarding Federal Reserve policy concerning the federal funds rate. In contrast, the performance of long-term bonds, which are harder to predict than short-term bonds, is significantly determined by expectations of inflation and economic growth rather than Federal Reserve policy.
The key point in this relationship is that while short-term yields are somewhat influenced by expectations of the Fed’s interest rate policy, long-term bonds are more affected by changes in broader outlooks. Thoughts on how the economy is performing tend to have a strong impact on the shape of the curve.
Strong or Weak Growth Indicators
When long-term bond yields rise faster than those of short-term bonds – meaning that long-term bonds are not performing as well as short-term bonds – the curve is said to be “upward-sloping.” This often means that investors expect stronger growth in the future. You must keep in mind that prices and yields move in opposite directions.
On the other hand, when short-term bond yields rise faster than yields on long-term bonds – or in other words, short-term bonds are not performing as well – the curve is said to be “flat.” This usually means that investors expect a slowdown in growth in the future.
It can rarely occur that the curve becomes “inverted.” This means that short-term bond yields are higher than long-term yields. When this happens, it means that investors believe that a recession, or even a crisis, is on the horizon.
To summarize, a curve that is upward-sloping or becomes steeper means that investors believe growth will improve. A curve that is flat or becomes flatter means that investors expect a slowdown in growth. The U.S. Treasury Department provides a daily yield curve table. You can plot these yields on a graph to create the curve.
The Accuracy of the Yield Curve as a Leading Indicator
To get an idea of how well the curve serves as a gauge of economic performance over time, you can look at the 2006 research paper titled “The Yield Curve as a Leading Indicator: Some Practical Issues,” written by Arturo Estrella and Mary Tribble from the Federal Reserve Bank of New York. In the paper, the authors state: “Since the 1980s, a wide range of literature has developed supporting the yield curve as a reliable predictor of recession and future economic activity in general. Indeed, studies have linked the yield curve with subsequent changes in GDP, consumption, industrial production, and investment.”
They note…
Also: “While most previous analyses focus on documenting historical relationships, using the yield curve as a real-time forecasting device raises a number of practical issues that have not been clearly resolved… The current diversity in approaches to producing and interpreting yield curve predictions may lead to incorrect readings of the signal in real-time.”
It should also be noted that the inverted curve has given strong signals over time. In fact, every one of the last seven recessions was preceded by an inverted curve. However, a study conducted by Credit Suisse showed that recessions come months after the inversion.
Causes of False Signals
One reason the curve may not always be accurate is that the role of the U.S. Federal Reserve’s policy is more important than ever. As a result, market fluctuations are more responsive to questions about the fate of certain policies rather than considering the extent of expected growth. One such policy is the bond-buying program known as quantitative easing, for example. Although expectations still play a key role in performance, investors must be cautious in using bond market performance to infer that the economy may be heading in a certain direction until the Federal Reserve begins to revert to a more traditional role.
The curve can change depending on how willing investors are to take risks. For example, when investors become anxious and execute a “flight to quality” away from high-risk assets, long-term bond prices often rise. This causes the curve to flatten. In this case, the shape of the curve changes, but the change may not be directly related to economic prospects.
Conclusion
Use the yield curve as a tool, but be cautious that it can give false signals. Like any freely traded financial asset, bonds can be influenced by central bank policy, investor sentiment, and other factors. Monitor the curve and use its signals with caution.
Source: https://www.thebalancemoney.com/can-bonds-predict-the-direction-of-the-economy-416906
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