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Final Report in Fixed Income Analysis
Typology: Study Guides, Projects, Research
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CENTRAL EUROPEAN UNIVERSITY
20 June 2016
1. Estrella (NY Fed) is quite certain that the yield curve is a good predictor of future economic activity. From the case, or the link to his FAQs, answer the following questions: a. How successful is the yield curve at predicting recessions? Economists often use a wide variety of mathematical models and tools to predict the path of the economy and the likelihood of the recession. However, simpler indicators such as the yield spread or stock price indexes also contain useful information about the expected economic activity. 1 The yield curve is the spread between the interest rates on the ten-year Treasury bond and the three-month Treasury bill. It was a quite good tool for predicting recessions since 1950’s except the “false” signal foresaw of 1967 recession. The yield curve is positively related with the economic growth, i.e. at times when the slope of the yield curve is positive the real GDP is expected to grow over the next four to six quarters and vice versa. However, due to some errors such as 1967’s, some economists was not convinced in the predictive power of the yield curve. Brian Sack, being an economist at Macroeconomic Advisers, conducted a study using a data for 43 years and came up with the following conclusion: even though he could not deny the econometric evidence of the predictive power of the term spread, he found some weak points in the statistical relationship such as large standard errors, sensitivity for outliers and different time periods estimation. Therefore, Brian Sack provided an opposite evidence of the yield curve than the Federal funds do. b. What type of securities and what maturities are best to use? United States Treasury securities are government debt instruments issued by the United States Department of the Treasury to finance the national debt of the United States. They are low-risk securities and frequently used on the yield curve as a good predictor of recessions which allows to avoid significant credit risk premiums. There are four types of marketable Treasury securities:
(^1) The Yield Curve as a Predictor of U.S. Recessions - Arturo Estrella and Frederic S. Mishkin (Current Issues in Economic and Finance - June 1996)
inversions and recessions. However, since 1960, a yield curve inversion (as measured by the difference between ten-year and three-month Treasury rates) has preceded every recession on record. In fact, in terms of monthly averages, the ten-year rate was at least 12 basis points below the three-month rate before every recession in that period. In contrast, very low positive levels of the spread have been observed without a subsequent recession. Specifically, there were two episodes in the 1990s in which the term spread attained very low positive levels (42 and 12 basis points respectively), but did not invert. In both of those cases, economic activity continued unabated after the troughs or low points for the spread. Thus, using inversion as a benchmark, there were no "false positives" during the period. While inversions and recessions may not be inevitably connected by theory, they correspond to extreme values of the term spread and output growth, respectively, which are in fact theoretically linked.^4
2. Richard Berner (Morgan Stanley) is a bit more skeptical about the predictive power of the yield curve. Does he just not understand Estrella’s overwhelming evidence, or does his skepticism rest on solid reasoning? In 2005, Richard Berner observed an increase in the demand for the long-duration bonds among institutions; more precisely, he focused on the pension funds demand for the Treasury bonds. Berners argued that this demand compressed the term premium and flattened the yield curve. Such flattening would put a downward pressure on the borrowing costs and, thus, would stimulate an economic activity. Moreover, Berner noted that there is another factor behind a compression of the term premium. He argued that Federal Reserve policy aimed to establish greater transparency resulted in decreasing volatility in the market and, therefore, mitigated the necessity of such a high protection against price and reinvestment risk, which in its turn decreases the compensation for holding long-dated fixed-rate assets. Therefore, due to Berner’s arguments, a flat yield curve would force people to invest in long-term assets rather than indicate the existence of the recession in the short-term.
(^4) https://www.newyorkfed.org/research/capital_markets/ycfaq.html#Q
3. What is Brian Sack’s (then Macro Advisers, now head of the Markets group at the NY Fed), take on the evidence Rodrigo put forward? Brian Sack was not completely agreeing with the Arturo Rodrigo. He did not rejected the predictive power of the yield curve, however, using a data for 43 years (form 1961 through 2004), as was already mentioned in the question 1.a, he found some significant problems with the study. High standard errors were very large; therefore, there existed a high probability of error even at 95% confidence level. Sack argued that statistical significance was not robust due to the following reasons: - Robustness to the exclusion of the outliers: removing them destroyed all statistical relationship between the real GDP growth between the year t and year t-1; - Any statistical relationship should be robust to being estimated over different time periods. Sack also provided another argument. He wrote an equation of the slope of the yield curve as an average of the expected changes in the short rate plus the term premium. He argued that it is not only the first part of the equation matters in the predicting recession, but also a term premium. Therefore, Sack came up with a conclusion that if the yield curve flattening would be driven by the changes in the term premium than it would be stimulative, which is opposite to the fact that a flattening precedes a growth slowdown. Therefore, Sack’s conclusion was directly counter to the New York Fed. 4. How is the U.S. yield curve currently sloped? How does this affect your forecast of economic activity?
Figure 1. The yield curve (1 July 2016)
