Updated May 1, 2008

Yield Curve Inversions andFuture Economic GrowthCampbell R. Harvey
Duke University, Durham, NC USA
National Bureau of Economic Research, Cambridge MA USA
Cam.harvey@duke.edu+1 919.660.7768 office || +1 919.271.8156 mobile
http://www.duke.edu/~charvey
1Issue• Current global financial turmoil focuses on the potential
impact of a U.S. recession• I pioneered in my 1986 dissertation at the University ofChicago a recession prediction model linked to the term
structure of interest rates• For over a year, the model has signaled a U.S. recession

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Historical Track Record• Yield curve measure attracted significant attention in
accurately forecasting the last six recessions• The measure also avoided false signals (for example, it
forecasted strong growth in 1988 after the October 1987
crash and it forecasted strong growth in 1999 after theAugust 1998 financial crisis).

3Evaluation of the 2001 Recession• In July 2000, the yield curve inverted forecasting recession
to begin in June 2001.
• Official NBER Peak is March 2001 (yield curve within
one quarter accurate).
• In March 2001, the yield curve returned to normal
forecasting the end of the recession in November 2001.
• On July 17, 2003 the NBER announced the official end ofthe recession was November 2001.

4Exhibit 1

Lead Lag Analysis in Months
Business Cycle

5-Year Yield Spread

NBER NBER
LengthLength ofPeak
Troughof Cycle Inversion Lead Normal Lead
Inversion
Dec-69
Nov-7012Oct-68
15Feb-70
1017
Nov-73Mar-7517
Jun-73
6Jan-75
320
Jan-80Jul-807
Nov-7815 May-80
319
Jul-81
Nov-8217
Oct-8010Oct-81
1413
Jul-90Mar-91
9May-89
15Feb-90
1410Mar-01
Nov-01
9Jul-00
9 Mar-01
99
Average last six
1212
915
Current Episode?
?

?

Jul-06

May-07115

Yield Curve Inverts Before Last Six Recessions(5-year Treasury note minus 3-month Treasury bill yield – constant maturity)
AnnualGDP growthor Yield Curve %% Real annual GDP growth

8
6
4
20

Yield curve-2Recession
Correct Recession-4
Correct 2 Recessions
Correct-6
72

74

76

78

80

82

84

86

88

90

92

94

96

98

00

02

04

06

19

19

19

19

19

19

19

19

19

19

19

19

19

19

20

20

20

20

08

70
1920

68
19

Data though Dec. 1986

6Source: Campbell R. Harvey. Update of Harvey (1986, 1988, 1989, 1991).

Yield Curve Inverts Before Last Six Recessions(5-year Treasury note minus 3-month Treasury bill yield – constant maturity)
AnnualGDP growthor Yield Curve %% Real annual GDP growth864
20

Yield curve-2Recession
Correct Recession-4
Correct 2 Recessions
Correct-6

Recentinversion
Yield curve accurate
in previous recession

Recession
Correct

72

74

76

78

80

82

84

86

88

90

92

94

96

98

00

02

04

06

19191919

19

1919

19

19

19

19

19

19

192020

20

2008

70
1920

68
19

Data though Apr. 2008

7Source: Campbell R. Harvey. Update of Harvey (1986, 1988, 1989, 1991).

Recent Annualized One-Quarter GDP Growth(10-year and 5-year Yield Curves-secondary market)
Annualized
1-quarter
GDP growth810-yearYield curve

4% Real annualized one-quarter GDP growth

6

3

4

2

2

1

0

0-2

5-yearBoth curves
invert 2000Q3-1Data though Apr. 2008

-2

M
ar
S e 95p
M -95
arS e 96pM 96
arSe -97pM 97
arSe -98pM 98
ar
S e 99pM -99ar
S e 00pM 00
ar
Se -01
pM 01
ar
Se -02
pM 02
ar
Se 03
pM -03ar
S e 04pM 04
ar
Se -05pM 05
ar
Se -06pM 06
ar
S e 07
pM -07ar
S e 08p08-4
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Current Recession Forecast• In July 2006, the Yield Curve inverts for 11 months• Lead time to NBER Peak is 9-15 months over last sixbusiness cycles• Model predicts recession beginning 2007Q4• Model predicts recovery beginning 2008Q49

Evaluation of Current Situation• Situation would appear dire:– Housing in free fall
– Credit crunch– $100+/bbl oil• In previous business cycles, any one of these factors could
push us into recession• However, the economy is much more resilient today…
why?

10Mitigating factors
1.

Housing. We face a bear market in housing for the next
two years. There is a huge inventory of vacant houses
that need to move. Nevertheless,••••housing investment is only 7% of GDP
While homeowners take a wealth loss, the impact of the loss
depends on when you bought the house (and the size of themortgage).
Fiscal policy
Monetary policy (recent cuts will reduce the pain of theadjustable rate resets)

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Current Situation
2. Oil. In contrast to 1973, 1979, 1981, oil expenditures are amuch smaller component of the GDP. Indeed, we havealready seen a large run up in the price of oil with little orno effect on economic growth. This is a sharp difference
from the previous oil price shock recessions.

12Current Situation
3. Credit crunch. Contrary to some perceptions, the world isawash in liquidity. Sovereign wealth funds appear to be
eager to invest in large financial institutions. There are also
substantial domestic resources actively purchasing (andwaiting to purchase) distressed assets.

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Current Situation

4. Financial risk sharing. While we mainly hear about U.S.
banks writing down the value of their subprime portfolio,
there have been substantial write downs outside the U.S.
(UBS, Bank of China, etc). This risk sharing dulls thenegative impact on the U.S. economy.

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Current Situation

5. Goods risk sharing. The size of the U.S. trade sector isdramatically larger than in the past. In addition, there arestrong growth expectations for many of our primarytrading partners. This means that a U.S. slow down can be(to some extent) deflected by strong foreign demand. Even
if international economies slow somewhat (e.g. China
dropping from 9% to 7% real growth), they still offset
much lower demand within the U.S. economy.

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Current Situation

6. No drastic corporate actions. U.S. corporate balance sheets
are in remarkably good shape. In contrast to previous
economic slowdowns, there is very little leverage. Thismeans that corporations do not need to go into emergency
mode and slash employment and/or halt capital investment.

16Interpretation• While we face three large risk factors, the outlook is notconsistent with a “deep recession”.
• The yield curve model is projecting a period of muchslower growth which could be classified as an official
NBER recession. However, the slower growth will beconsistent with the growth rates in 2001 and 1990-91.
• GDP for Q4 2007 and Q1 2008 is running at only 0.6%
growth is consistent with the model timing• In contrast to previous two recession, the current
slowdown will be longer (a full year).
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Yield Curve and GDP Research Chronology• Campbell R. Harvey’s Ph.D. Thesis, University ofChicago, 1986.
• Campbell R. Harvey, “The Real Term Structure andConsumption Growth,” Journal of Financial Economics,1988• Seven other works found at:
http://www.duke.edu/~charvey/research_term_structure.htm

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