The yield curve has lost its luster, contends Douglas Ramsey, senior research analyst of Leuthold Group.
His research "casts doubt on whether the obsession over a possible yield curve inversion is even worthwhile," he wrote in the April issue of Perception, a report produced monthly by the Minneapolis-based firm for clients.
"Our work suggests that the forecasting reliability of the curve has diminished severely in the past 10 to 15 years."
The yield curve "has been of limited use to economists over the past decade," he wrote. The "relationship between the yield curve and the economy is not as tight as it once was," he noted. The "heydays of the yield curve" were the years 1965 to 1985, when it was "a terrific economic forecasting tool," he wrote. In that period, the yield curve impacted real gross domestic product with "very high correlations of 0.67 and 0.68," he stated.
Shifts in the yield curve typically would affect the economy within four to six quarters, or 12 to 18 months, he noted.
But in the 1986 to 1995 period, the correlation fell to 0.56 and the impact of a shift "was not fully felt until eight quarters after a given shift in the yield curve," he wrote.
In "the last 10 years, yield curve movements had virtually no impact on real GDP growth during the normal four- to six-quarter window in which their effects are normally felt," Mr. Ramsey stated.
In that last 10-year period, "the correlation has fallen even further (to 0.37), with the impact the strongest after a 10- to 11-quarter lag," he added.
Why has the yield curve's predictive power diminished?
"I think a big piece of it is that the economy has become more internationalized," Mr. Ramsey said in an interview. Some "30 or 40 years ago, the net export piece of GDP was relatively small; it was much easier for the (Federal Reserve) and (its) monetary policy to impact the economy."
"Now you look at a big piece of trade (within the GDP) and it is more difficult for the yield curve to be a market-based measure of economy," he added. It is "more difficult to stimulate foreign demand with monetary policy than it used to be. Also with the Fed telegraphing their intentions so far in advance, you don't have the surprise factor as you did in the past when Fed policy wasn't as transparent."
Still, he believes the yield curve retains some value as a tool for economic insight. "I still think it is a good measure of market-based economic policy," he said. "To the extent you have inflationary expectations embedded in long-term interest rates, the spread between long- and short-term rates is still an effective market-based measure of Fed policy."
"To some extent it is also a measure of risk taking. But as an economic forecasting tool, I think it has lost its luster," he said.
"An extremely steep yield curve is stimulative to the economy," he said. "But a flat or inverted yield curve, traditionally has led to a recession in the next four of five quarters. But given the diminishing impact of the yield curve, I'd be hard pressed to draw that conclusion (now)."
At this time, the yield curve by traditional measures is still positive, albeit close to flat, he noted, while the economy is strong.
Given that "trade is a much bigger piece of the economy, I don't think (the yield curve) will get back to as tight a relationship with the economy as we had in the 1960s and 1970s."
