What is the Interest Rate Spread?
The interest rate spread is a simple and powerful tool for forecasting recessions and has recently been added as a component of the Conference Board's Index of Leading Economic Indicators. The interest rate spread used by the Conference Board is found by subtracting the Fed funds rate (the rate that banks charge one another for overnight loans) from the yield on the 10 year U.S. Treasury bond. In order to understand the predictive power of the interest rate spread, it would be useful to review the concept of bond yield.
Recall that the yield on a bond is the coupon interest rate paid on the bond, divided by the prevailing market price of that bond. Once a bond is issued, the coupon interest rate is fixed, and so if prevailing market interest rates rise, then the price of the bond will fall so that the bond yield is consistent with prevailing interest rates. Bonds have different term structures, meaning the time period before they mature and are repaid, such as U.S. Treasury bills (one year or less), notes (one to 10 years), and bonds (10 or more years). Yield usually differs by term structure, as illustrated by a yield curve (the interest rate spread simply compares two points on a yield curve). For example, between 1993 and 1995 the yield on 3-month U.S. Treasury bills averaged 4.25 percent, while the yield on 10-year U.S. Treasury bonds averaged 6.51 percent, and the yield on 30-year U.S. Treasury bonds averaged 6.95 percent.
As the example above suggests, more often than not the yield curve is upward sloping, and thus the interest rate spread is positive, meaning that yields increase as time to maturity increases. There are a number of theories that have been developed to explain this shape of the yield curve, among them that the higher yield on longer-term bonds compensates investors for greater exposure to the risk of changes in future interest rates. Occasionally the yield curve becomes downward-sloping or inverted, and thus the interest rate spread is negative. To understand why, first note that interest rates usually decline during a recession. If investors anticipate a recession in the near future, they will sell their short-term bonds and buy longer-term bonds to carry them through the recession. The selloff of short-term bonds will lower their price, and thus raise their yields, while the buying-up of long-term bonds will raise their price and thus lower their yield. If these two effects are sufficiently strong, the interest rate spread can invert, or become negative.
The interest rate spread inverted about a year in advance of each of the five U.S. recessions since 1969. In fact, the U.S. economy has never had a recession in the post-World War II period that was not forecasted by a flattened or negative interest rate spread. Consequently the simple interest rate spread has a better record of forecasting recessions than most professional forecasters using elaborate and expensive econometric models. You can read more about using the yield curve to forecast recessions in an article by Arturo Estrella and Frederic S. Mishkin, entitled "The Yield Curve as a Predictor of U.S. Recessions," in the June 1996 issue of Federal Reserve Bank of New York's Current Issues in Economics and Finance.
In recent years the interest rate spread inverted in 1998, and again in 2000 and the first quarter of 2001. While the first of these inversions may have been due in part to the Asian financial crisis (1998) and government buybacks of U.S. Treasury bonds in order to reduce the national debt, it is now clear that the inversions in 2000 and 2001 forecasted the recession that began in the first quarter of 2001 and continued into 2002.
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