The yield spread, explained

The yield spread originated from research at the Federal Reserve Bank of New York (NY Fed) in the 1980s. Economists Arturo Estrella and Gikas A. Hardouvelis published this research in a 1991 article at the NY Fed: The Term Structure as a Predictor of Real Economic Activity. [These articles are found on Card 7]

This seminal paper focused on the yield spread’s ability to predict past recessions. That is, the yield spread was useful in hindsight. Estrella co-authored a second article in 2006 on using the yield spread to forecast economic recessions in real time.

The National Bureau of Economic Research defines a recession as a period of at least three quarters of significantly declining economic activity, including decreasing gross domestic product (GDP) and falling employment.

The yield spread shows us that recessions are completely predictable and in fact planned in order to keep the economy in check.

A normal, “healthy” yield spread is positive. That is, the long-term rate is higher than the short-term rate.

When the short-term rate is higher than the long-term rate, the yield spread becomes inverted, or goes negative. When this happens the probability of recession in the next 12 months is almost certain.

Why does this relationship exist? It all has to do with the interplay between:

• monetary policy (viewed in the short-term rate) and;
• bond market or investor future expectations (viewed in the long-term rate).

The Fed’s use of short-term interest rates and other infusions and withdrawals of dollars to control the economy is known as monetary policy.

The Fed has the ability to:

• lower interest rates and stimulate economic growth to stave off deflation or economic stagnation; or
• raise interest rates and slow economic growth to fight inflation.

On the other end are members of the bond market (a non-government entity). They watch inflation just as closely as the Fed, and:

• demand higher long-term rates when the economy is stagnant; or
• accept lower long-term rates when the economy is overheated, in anticipation of Fed action to raise the short-term rate.

When the economy is overheating or inflation is rising well beyond the Fed’s target rate of 2%, the Fed tightens monetary policy. Too much inflation leads to an unstable economy, and a more severe bust when the economy does crash. Thus, the Fed maintains control over the economy by creating its own recession.

When a recession is imminent, short-term rates rise and long-term rates fall, reflected in the narrowing spread between the two rates. This is viewed in a decreasing yield spread. In other words, the falling yield spread is not the cause of the coming recession; rather it is a strong indicator that a recession will occur within 12 months.

On the other hand, a widening yield spread indicates little chance of recession and makes a strong case for economic expansion in the coming months.

Yes and no. Yes, the yield spread correctly predicted the 2008 Great Recession, the briefer 2001 recession, the 1989 recession… and all other recessions going back to World War II.

However, movement in the yield spread needs to be considered alongside other economic factors to accurately forecast your local economy. That’s because, despite living in an increasingly globalized economy, the effects of a nationwide recession or economic recovery can vary greatly by location.

For instance, local economic performance depends on:

• the types of industry in the local job market; and
• your geographic location, as California economies tend to suffer less and rebound quicker on the coast than inland.

For example, San Francisco (a coastal city with a large, successful tech industry) recovered all jobs lost in the 2008 recession by October 2013. In contrast, it took Riverside (an inland city mostly considered a bedroom community of Los Angeles and San Diego) nearly two years longer to recover all jobs lost in the 2008 recession.

Thus, the yield spread is helpful on a broad, nationwide scale. A rising yield spread does not signify economic prosperity for all, nor does a falling yield spread herald impending disaster for each and every individual. However, it is a helpful tool to forecast future conditions for your local market when considered alongside other economic indicators.

Keeping an eye on the yield spread is helpful when planning for real estate sales in the year to come.

When the yield spread goes negative, expect a reduced volume of sales (which may by then already be slipping), lending and leasing one year forward. Then, in another 12 months, there will be a drop in real estate prices, mortgage originations and rents. Agents can adjust their conduct to prepare for the coming months of low sales volume and prices.

Read more about using the yield spread and view the yield spread chart at: Using the yield spread to forecast recessions and recoveries.

Read more about buy, sell and hold phases of real estate at: How to time the market.

To read more about how the Fed creates a recession, see: Suspect behavior: why and how the Fed creates a recession.

For access to the original 1991 article positing the yield spread curve as a forecast for economic growth, see: The Term Structure as a Predictor of Real Economic Activity, originally published by the New York Fed. [You may require library access to view the full article]

For an update on using Estrella’s original research to forecast with the yield spread in real time, see Estrella’s 2006 article: The Yield Curve as a Leading Indicator: Some Practical Issues, from the New York Fed.

To read about using the yield spread curve’s level and slope for precise economic forecasting, see: Forecasting with the Yield Curve: Level, Slope, and Output, from the Cleveland Fed.