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Do yield curves predict

| Posted by: Paul Donovan | Tags: Paul Donovan Weekly

  • Traditionally, bond yield curves (the gap between 10-year yields and policy interest rates) were thought to predict economic growth. If the yield curve is "steep" with 10-year yields higher than policy interest rates, growth should rise. If flat or inverted, growth should slow.
  • This seems logical. If a central bank cuts policy rates (steepening the curve) investors expect stronger future growth. If investors expect stronger future growth, investors need compensation for higher inflation risks and demand higher bond yields (steepening the curve).
  • There are three problems with this analysis today.
  1. Central banks no longer use policy interest rates alone. A central bank could tighten quantitative policy to slow growth, steepening the curve.
  2. In the 1970s, inflation was the dominant part of a bond yield; inflation moved up and down with growth. Today, inflation is a far smaller part of bond yields.
  3. Regulation and central bank bond buying (for quantitative policy and foreign exchange management) produces a captive pool of investors. These investors buy bonds because they have to, not because of expectations about the economy.
  • The logic of bond markets predicting growth has weakened. It may be better to trust economists than bond markets to predict future growth.