How Good of a Predictor is the Yield Curve?

How good of a predictor is the yield curve? Economists Michael Bordo and Joseph Haubrich dug through the data and found the answer. It depends.

The results are intriguing. They surveyed many distinct periods in U.S. financial and monetary history, from the era of the classical gold standard to the creation of the Fed to the breakdown of the gold standard, its resurrection on the international level under Bretton Woods, and its eventual collapse in 1971.

They found that the utility of the yield curve had a great deal to do with the monetary regimes of the day. In particular, they found that the yield curve worked better as a predictive tool when the monetary system was out of kilter and inflation a problem, and worse when the monetary system was predictable and inflation stable.

In other words, it would seem that the utility of the yield curve is inversely related to the credibility of the monetary regime. When the market thinks that inflation could spiral out of control because of the incompetence of policy makers, the yield curve works pretty well. But when inflation is kept in check, you can’t take the yield curve as seriously.

Which brings us to today. Although we still don’t know for certain what the yield curve is telling us, the possible answers come into sharper focus. If the market is sensing that the Fed doesn’t have a hold on inflation, then perhaps the yield curve is unequivocally signaling a recession. But if inflation isn’t a threat, then the yield curve could be giving us a misleading reading.

Right now, there’s almost no sign that inflation is about to spin out of control. And that, perhaps, is a sign that the crystal ball known as the yield curve is too cloudy to trust.

Here’s their study.

Posted by on August 8th, 2016 at 3:36 pm


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