Curve Watching Beats Room Full of Forecasters

It’s a funny thing about long-term interest rates. They’re pro-cyclical. They tend to rise when the economy is doing well, when demand for credit is strong. They fall when the economy is in the tank, and the private sector isn’t much interested in investing and spending.

Unlike market-determined long-term rates, the overnight interbank lending rate is set by the central bank. Other short- term rates gear off the fed funds rate, with an added premium for perceived risk. Long-term rates are the sum of the current and expected future short-term rates. With short rates virtually at zero, what would falling long rates say about prospects for the U.S. economy?

“If you think monetary policy matters, you should care about the spread,” says Jim Glassman, senior economist at JPMorgan Chase & Co. With the Fed’s “ability to anchor short- term rates at artificial levels, the spread is a way of looking at the stance of monetary policy.” Rudebusch and Williams found forecasters to be slow learners when it came to incorporating the “usefulness of the yield spread for forecasting recessions,” they say in “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve.”

Even when economists are fully apprised of the yield curve’s “significant real-time predictive power for distinguishing between expansions and contractions several quarters out,” they find a way to explain away the message.

Read the full story…