The reason for this is that people who put money into the market look to the future in choosing what to invest in. At any point, market prices reflect, or “discount,” to those who invest in what’s to come. The bond market is mostly driven by future economic growth. Its impact on the interest rate outlook is seen as being a way to see how the economy could perform in the coming year. This isn’t to say that the bond market is always right. Bond investors, as a group, are seen as being “smart money” and less prone to the type of guessing seen in stocks or commodities. As a result, bonds have a fairly strong track record as a way to predict what the economy will look like in the near future. For that reason, they are often used by experts as a leading indicator. If nothing else, the bond market can provide a gauge of what investors think when it comes to the economy at any given point. This is true even it proves to be wrong.
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. Yield is the return or income that an investor will get from buying and holding a bond. The “yield curve” is simply bonds of varying maturities from one month to 30 years. The bonds are plotted on a graph based on their returns. The curve typically slopes upward, since investors demand higher returns for holding longer-term bonds. Since yields for bonds of all maturities change every day due to market ups and downs, the “shape” of the curve is always changing. It is these changes that provide insight into the economic outlook.
The Long and Short of the Bond Yield Curve
Short-term bonds are those which mature in two years or less from the date they are bought. How well they do is driven by expectations related to future Fed policy with regard to the federal funds rate. In contrast, the performance of longer-term bonds, which are harder to predict than short-term bonds, is largely driven by the outlook for inflation and economic growth rather than Fed policy. The vital aspect of this linking to know is that while short-term returns are “pinned” to some extent by expectations for the Fed’s rate policy, longer-term bonds have more ups and downs based on shifts in the broader outlook. Thoughts about how the economy will do tend to have a strong impact on the shape of the curve.
Stronger Growth or Slowing Indicators
When the yields on long-term bonds rise faster than those on short-term bonds—which means long-term bonds are not doing as well as short-term bonds—the curve is “steepening.” This most often means investors see stronger growth ahead. Keep in mind that prices and yields move opposite of each other. On the other hand, when returns on short-term bonds are rising faster than the yields on long-term bonds—or in other words, short-term bonds are the ones not doing well—the curve is said to be “flattening.” This most often means that investors see slowing growth ahead. Rarely, the curve can become “inverted.” This means that short-term bond yields are higher than long-term bond yields. When this is the case, it means that investors think a recession, or even maybe a crisis, lies ahead. To recap, a curve that is steep or getting steeper is a sign that investors think growth will improve. A yield curve that is flat or getting more flat is a sign of slowing growth. The U.S. Treasury offers a table of the daily curve rates. You can plot these rates onto a chart to create the curve.
The Accuracy of the Yield Curve as a Leading Indicator
To gain a sense of how good the curve is as a measure of how well the economy will do over time, look at 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: They also note: It should also be noted that the inverted curve has given strong signals over time. In fact, each of the last seven recessions has followed an inverted curve. Still, a study by Credit Suisse showed that a recession comes months after the inversion.
Reasons for False Signals
One reason that the curve may not always be exact is that the role of U.S. Federal Reserve policy is more vital than ever. As a result, the market’s ups and downs are more often a response to questions about the fate of certain policies rather than thoughts about how much growth to expect. One such policy is the bond-buying program known as quantitative easing, for instance. While the outlook still plays a major, driving role, investors need to be prudent in using how the bond market performs to conclude the economy may be going a certain way until the Fed begins to revert to a more traditional role. The curve can change as a result of how much risk an investor is willing to take on. For instance, when investors grow nervous and stage a “flight to quality” away from higher-risk assets, longer-term bonds will often rally. This causes the curve to flatten. In this case, the shape of the 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 feelings, and other factors. Keep an eye on the curve, and take its signals with a grain of salt.
