Monday, January 19, 2009

The Battle of the Spreads

The treasury yield curve spread--the interest rate on a long-term treasury minus the interest rate on a short term treasury--has been a good indicator of future economic activity. Typically, if the spread turned negative a recession was looming and vice versa. The corporate bond yield spread--the interest rate on a risky corporate bond minus the interest rate on a safer corporate bond--has also been a good indicator of future economic activity. Here, if the spread significantly increased in value then a recession was looming and vice versa. So what do these spreads now show? Are there any signs of hope? First take a look at the 10-year treasury yield minus the 3-month treasury yield spread in the figure below. (click on figure to enlarge.)

As you can see from the figure, the spread is currently relatively large and positive, usually a sign of economic growth ahead. This fact was noted by the Cleveland Fed recently as indicating the recession may soon be over. However, Paul Krugman took issue with this interpretation:
The reason for the historical relationship between the slope of the yield curve and the economy’s performance is that the long-term rate is, in effect, a prediction of future short-term rates. If investors expect the economy to contract, they also expect the Fed to cut rates, which tends to make the yield curve negatively sloped. If they expect the economy to expand, they expect the Fed to raise rates, making the yield curve positively sloped.

But here’s the thing: the Fed can’t cut rates from here, because they’re already zero. It can, however, raise rates. So the long-term rate has to be above the short-term rate, because under current conditions it’s like an option price: short rates might move up, but they can’t go down.


So sad to say, the yield curve doesn’t offer any comfort. It’s only telling us what we already know: that conventional monetary policy has literally hit bottom.
So Krguman does not take solace in the current yield curve spread. Does his interpretation find support in corporate bond yield spread? Or does it provide some sign of hope? The figure below provides an answer. It plots the corporate BAA yield minus the corporate AAA yield spread. (Click on figure to enlarge.)

This figure suggests Krugman's view is correct: the corporate yield spread is the largest it has been since the Great Depression. No sign of soon recovery here.

Update: Paul Krugman replies to Dean Baker's assertion that corporate yields do not show a credit crunch.


  1. I am not sure about corporate spreads (I am still little dumb there).

    But, regarding Treasuries, Krugman is wrong if he thinks short and long term rate are related at equilibrium. The Treasury yield curve will be composed of independently distributed variables (short, medium, and long rates) at equilibrium.

    This result falls out of estimation theory. The best metaphor for the yield curve is that it is half of the Gaussian windowed Fourier transform of economic output.

  2. Matt:

    Krugman is simply applying the expectation hypothesis for the term structure of interest rates to the current economic crisis. His story is a reasonable one based on this view.

  3. I believe Michael Dueker's qualvar forecasting model encompasses the variables you mention. His model predicts the trough at August.


    See attached.