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Is the negative UK yield spread warning of recession?Economics Weekly: Economic Research and Analysis – Is the negative UK yield spread warning of recession?
Yield curves and recessions
Many people have argued that the negative yield spread (where long term interest rates are lower than short term interest rates) in the UK has been suggesting that recession is possible. That has been one factor helping to encourage the view that UK interest rates will be cut later this year or in early 2006. But our research shows that this interpretation of the link between the yield curve and economic growth is not the correct one to draw. That is the subject of this week’s briefing.
Yield curves linked to economic growth
Yield curves and economic growth have history. It has been noticed that recessions – two consecutive quarters of falling economic growth – have been preceded by a decline in the spread between long and short term interest rates. This relationship seemed to hold true much of the time and over extended periods. Thus, instead of all of the constant reading of a plethora of complicated economic statistics, all observers need do instead is look at the yield curve spread. This is based on the assumption that the financial markets have taken account of all of the risk from all of the information about economic trends in their pricing actions. Chart A shows that there is indeed a remarkably close link between the yield spread and recessions in the UK. It also suggests that it is not the change in the yield spread that matters for growth but its level.
What accounts for this link?
A tightening of monetary policy occurs when short term interest rates are raised, perhaps to head off higher inflation. Usually this implies that the yield curve would steepen, with high interest rates expected to persist for some time. If the change in interest rates is not judged to be permanent, then long term interest rates do not rise as much as short term interest rates and so the yield curve flattens. If the rise in interest rates leads to weaker growth and lower interest rates then the yield spread relationship will have been proved to be valid.
Market expectations also play a role in making the relationship have some authenticity. If interest rates are determined by demand for money and a premium for inflation risk, then a rise in short term interest rates could cause long term interest rates to fall because of the expectation that higher short term interest rates will lead to weaker economic growth, weaker inflation and a lowering of the demand for credit. This also means that the observed link with the negative yield curve spread and economic growth will hold.
The relationship can break down, however...
Chart A shows, however, that this link is not infallible, though every recession is usually preceded by a rise in short term interest rates, which then falls as the recession either commences or is under way so that the curve should flatten and turn negative as expectations are that interest rates will be cut back to normal levels. However, close examination of the chart shows that purely looking at a negative yield gap and expecting recession would be the wrong conclusion to draw. In the time period we are observing, there have been about two occasions, possibly three, when the yield curve approach would have been proved wrong: in 1984, 1997 and perhaps 2000. (This is leaving aside the current situation which we cannot yet say is another case of the yield spread approach being wrong, although it is increasingly looking like it).
...and this be happening now
The model seems to need adjusting to include not just the yield spread but also the length of time the spread is negative. Otherwise false signals are sent. This is the same as saying that the probability of the event taking place is not high enough. Chart B shows that if the yield spread is less than minus 4%, then it could send a false signal. It is clear from this chart that only when the negativeratio is large and persistent (-4 to -5%) is there a real risk of recession. In the period we look at, there have been two recessions and two or more false signals. This latest yield spread does not rank as a signal and is false in our opinion, though it still too soon to be sure. Economic relationships can and do shift and short term financial market imbalances can send misleading signals, but the yield spread still seems to have some value. What it seems to be saying currently is that there is recession risk in the UK, but it is low and interest rates are highly unlikely to be cut aggressively.
UK economic indicators
There are few UK economic indicators out this week. Attention will probably be on house price data and CBI industrial orders. We look for house prices to show that in monthly terms the market is stabilising, though the annual rate will continue to edge down. CBI data may show that some mild improvement in trading conditions for companies is taking place. This would be in line with the quarterly gdp data released last week, which showed that output rose by 0.4% in Q3, and survey data, including the Lloyds TSB Financial Markets monthly business barometer.
Trevor Williams, Chief Economist
Lloyds TSB Bank,
London EC3R 8BQ
0207 283 - 1000
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