Can Bonds Predict the Direction of the Economy?
The Bond Market as a Forecaster of Economic Conditions
Bond market performance is generally being viewed as an indicator of economic conditions, but in reality, it’s more accurate to say that it reflects investor expectation of future economic conditions six to 12 months out.
The reason for this is that market participants anticipate the future in making investment decisions, so at any point market prices reflect, or “discount” the consensus expectation of what’s to come.
The bond market, which is largely driven by expectations for future economic growth and its impact on the interest rate outlook, is therefore seen as being a predictor of how the economy is likely to perform in the coming year.
This isn’t to say that the bond market is always right. However, bond investors – as a group – are generally seen as being “smart money” and less prone to the type of speculation seen in stocks or commodities. As a result, bonds actually do have a fairly strong track record as a predictor of economic conditions, and for that reason, they are often used by economists as a leading indicator. If nothing else, the bond market can provide a gauge of the consensus expectation regarding the economy at any given point – even if that expectation sometimes proves incorrect.
Using the Yield Curve to Predict the Economy
With this as background, the best way to use bonds to predict the economy is to look at the yield curve.
The “yield curve” is simply which is the yields on bonds of varying maturities (typically from three months to 30 years) plotted on a graph based on their yields. The yield curve typically slopes upward, since investors demand higher yields for longer-term bonds.
Since yields for bonds of all maturities change every day due to market fluctuations, the “shape” of the yield curve is always changing – and these changes provide insight into the economic outlook.
Here’s why: the performance of short-term bonds (those with maturities of two years or less) is most directly impacted by expectations regarding future Federal Reserve policy with regard to the federal funds rate. In contrast, the performance of longer-term bonds – which are more volatile than their short-term counterparts – is largely driven by the outlook for inflation and economic growth rather than Fed policy.
The important aspect of this relationship to understand is that while short-term yields are “pinned” to some extent by expectations for the Fed’s rate policy, longer-term bonds experience higher volatility based on shifts in the broader outlook. Expectations for the economy, therefore tend to have a strong influence the shape of the yield curve.
Here’s how the shape of the yield curve can change: when the yields on long-term bonds rise faster than those on short-term bonds (which indicates that long-term bonds are underperforming short-term bonds), the yield curve is “steepening.” This typically indicates an environment in which investors see stronger growth ahead. (Keep in mind, prices and yields move in opposite directions.)
On the other hand, when yields on short-term bonds are rising faster than the yields on long-term bonds (or in other words, short-term bonds are underperforming), the yield curve is said to be “flattening.” This is usually an indication that investors see slowing growth ahead.
On rare occasions, the yield curve can become “inverted”—meaning that short-term bonds yields are actually higher than long-term bond yields. When this is the case, it indicates that investors see a high likelihood of a recession—or even a potential crisis—ahead.
In summary, a yield curve that is steep or becoming steeper is a sign of expectations for improving growth; a yield curve that is flat—or becoming flatter—is a sign of expectations for slowing growth.
How Accurate is the Yield Curve as a Leading Indicator?
To gain a sense of the historical accuracy of the yield curve as a predictor of economic conditions, we can turn to the 2006 paper titled “The Yield Curve as a Leading Indicator: Some Practical Issues,” written by Arturo Estrella and Mary R. Trubin of the Federal Reserve Bank of New York.
In the piece, the authors state: “Since the 1980s, an extensive literature has developed in support of the yield curve as a reliable predictor of recessions and future economic activity more generally. Indeed, studies have linked the slope of the yield curve to subsequent changes in GDP, consumption, industrial production, and investment.” However, they also note “Whereas most earlier analysis has focused on documenting historical relationships, the use of the yield curve as a forecasting device in real time raises a number of practical issues that have not been clearly settled …How should the slope of the yield curve be defined? What measure of economic activity should be used to assess the yield curve's predictive power? The current variety of approaches to producing and interpreting yield curve forecasts may lead to misreadings of the signal in real time.”
Having said this, it should also be noted that the inverted yield curve has given strong signals over time. In fact, each of the last seven recessions has been preceded by an inverted curve.
Reasons for False Signals
One reason that the yield curve may not always be accurate, especially today, is that the role of U.S. Federal Reserve policy is more important than ever. As a result, the market’s movements are more often a response to questions surrounding the fate of policies such as the bond-buying program known as quantitative easing than they are a reflection of growth expectations. While the economic outlook certainly continues to play a major, driving role, investors need to be cautious in using bond market performance to draw hard conclusions about the economy until the Fed begins to revert to a more traditional role in the economy.
The yield curve can also be affected by the level of investors’ risk appetites. For example, when investors grow nervous and stage a “flight to quality” away from higher-risk assets, longer-term bonds will often rally (causing the yield curve to flatten). In this case, the shape of the yield curve is changing, but the change may not be directly related to the economic outlook.
The Bottom Line
Use the yield curve as a tool, but be wary that it can give false signals. Like any freely traded financial asset, bonds can be influenced by central bank policy, investor emotions, and other undetermined factors. So keep an eye on the curve – just take its signals with the appropriate grain of salt.