Tuesday, June 25, 2019

BofE: "All bark but no bite? What does the yield curve tell us about growth?"

From the Bank of England's Bank Underground:
The slope of the yield curve has decreased in the US and the UK over the last few years (Chart 1).

This development is attracting significant attention, because the yield curve slope (i.e. the difference between longer term government bond yields and shorter term government bond yields) is a popular business cycle indicator, and a fall of longer term yields below shorter term yields (i.e. an ‘inversion’ of the yield curve) has historically been considered as a powerful signal of recessions, particularly in the US. 

Chart 1: Slopes of the US and UK government bond yield curves (10-year yields minus policy rates)
Since Estrella and Mishkin (1998), a number of studies have documented that the slope of the yield curve has significant power in predicting economic slowdowns (see e.g. the recent survey by Claessens and Kose, 2017).  However, some – including FOMC members (e.g. Chair Powell) – have suggested that the slope of the yield curve is likely to contain less signals on the growth outlook than it has done in the past due to a number of changes that have taken place in interest rates markets.
To answer the question, in this post we analyse how the yield curve has performed as a predictor of GDP growth over time in the US and the UK, focussing on the performance of the different components of the yield curve: expected short interest rates and term premia.

How has the yield curve slope performed as a predictor of GDP growth over time?
We start by comparing the predictive power of different measures of the US and UK yield slope for GDP growth one year ahead. Specifically, in a similar spirit to Stock and Watson (2003), we predict the annual growth in real GDP one year ahead with the relevant yield curve slope, controlling for the latest available outturns of annual growth rate in GDP in real time and two additional lags. In other words, we condition the GDP forecast 1-year ahead only on the information available at each point in time. We use quarterly data since 1966 for the US, and a shorter series for the UK – since 1982, because of data availability. Within this framework, we analyse forecasts produced using a rolling estimation scheme (with a starting window of 15 years), and compare them with the forecasts obtained from autoregressive models that are based only on lagged GDP growth variables.....