Thursday, October 30, 2008

Decomposing the Yield Curve Spread

Just last week I had a post titled "The Interest Rate Conundrum that Wasn't" where I discussed how many observers misread the flattening and then the inverting of the yield curve over the 2005-2007 period. As I noted then, the popular story was that the term premium was falling and thus there was nothing to fear from the changes in the yield curve. As we all now know, this interpretation was incorrect: the yield curve was telling us that a recession was in the making after all. Well today, Zubin Jelveh directs us to a similar posting he made back in January titled "That Trusty Yield Curve". The entire post is worth reading, but one part in particular I want to mention here. Zubin notes a study by Joshua Rosenberg and Samuel Maurer that decomposes the yield curve spread into its (1) interest rate expectations and (2) term premium components. What they find can be seen in the following figure where the gray columns denote recessions: (click on figure to enlarge.)

This figure shows--and the authors demonstrate more formally with some statistical tests--that it is changes in the interest rate expectations component that predicts recessions, not changes in the term premium. The variation in the term premium is typically too small to matter, including during the "conundrum" period. This is interesting work.

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