Investing

Arturo Estrella at the New York Federal reserve published research that linked the yield curve to the probability of an upcoming recession. His research was US based but I thought it would be interesting to see how effective it may be applied to Australian data. (Subsequent research has shown a good correlation in Germany).

Time since last recession	Date Yield Curve First Inverted	Next Recession	Length inversion (months)	Weeks to slowdown	Length -VE GROW(months)	Years since last recession
Dec-71	Sep-73	Sep-75	15	104.00	6.0	3.75
Sep-75	May-76	Mar-77	2	43.31	3.0	1.50
Mar-77	Apr-77	Sep-77	20	21.80	6.0	0.50
Sep-77	Apr-79	Jun-79	2	8.69	3.0	1.75
Jun-79	Feb-81	Dec-81	8	39.18	6.0	2.50
Dec-81	Dec-81	Sep-82	10	39.04	9.0	0.75
Sep-82	Mar-85	May-86	28	60.69	3.0	3.67
May-86	May-88	Dec-89	28	82.49	3.0	3.59
Dec-89	Oct-90	Mar-91	7	21.51	9.0	1.25
Mar-91	Aug-00	Dec-00	7	17.38	3.0	9.76
			avg weeks to slow	43.81
			Median	39.11

Using this data it seems that every inverted yield curve leads to at least an economic slowdown (only one quarter of negative economic growth) if not a recession (2 quarters of negative growth). The time differences were pretty long but looking at the correlations between the yield curve and future economic growth it seems that 19 months has the highest correlation. (I tested actual yield curve against actual growth and combinations of a binary inverted or not and a binary economic growth or not indicator).

The correlation at 19 months never got above 0.3 so I think that the median or mean are probably the better indicators. Given that the standard deviation is around 30 weeks (because there are so few observations), it seems reasonable to assume that you will see a quarter of negative economic growth within 12-18 months of an inverted yield curve.

Probability of a recession

The size of the inversion has also been linked to the probability of recession.

Probability of recession	Spread (in percentage points)
5%	1.21
10%	0.76
15%	0.46
20%	0.22
25%	0.02
30%	-0.17
40%	-0.50
50%	-0.82
60%	-0.08
70%	-1.46
80%	-1.85
90%	-2.40

Source: Federal Reserve Four Quarters Ahead
Note: The yield curve is defined as the spread between the interest rates on the 10-year Treasury note and the three-month Treasury bill.

In the US the yield curve has been shown to be predictive at 6 months. There is a weak positive correlation in Australia also, so it is reasonable to also assume that as the inverted yield curve becomes even more inverted the chance of a recession increases. This isn't really borne out in my very limited sample;

Date Yield Curve First Inverted	Length inversion	Weeks to slowdown	max inversion	average inversion	median
Sep-73	15.00	104.00	-12.03	-3.07	-1.02
May-76	2.00	43.31	-0.07	-0.06	-0.06
Apr-77	20.00	21.80	-1.56	-0.51	-0.34
Apr-79	2.00	8.69	-0.52	-0.43	-0.43
Feb-81	8.00	43.17	-3.39	-1.26	-0.93
Dec-81	10.00	39.04	-4.79	-1.82	-1.77
Mar-85	28.00	60.69	-5.49	-2.41	-2.09
May-88	28.00	82.49	-5.15	-2.57	-1.79
Oct-90	7.00	21.51	-0.64	-0.32	-0.31
Aug-00	7.00	17.38	-0.68	-0.38	-0.45
Average	12.7	44.21	-3.43	-1.28	-0.92

Reserve Bank of Australia
It is very likely that the Reserve Bank of Australia will continue to raise interest rates especially as the resource boom accelerates. There are already significant capacity constraints in the economy including employment and infrastructure. Here are a couple of articles on the infrastructure problems: The Australian, DOW JONES . There will be significant inflation in Australia if rates aren't raised quite a bit higher. The reasoning is simple, if I need to ship my coal I will pay more and more for the limited supply of infrastructure or people (demand is up and supply is constant). The reserve bank can head this off by increasing the risk free rate and making less profitable projects suspend or fold thereby reducing demand. They will also free up resources from the non-resources parts of the economy.

The UK and New Zealand already have inverted yield curves and the US is quite close.

What about the resources sector
It is likely that the economy will behave as two separate economies, the resources economy and the rest. Mining and agriculture make up about 8% of GDP. It is easy to see how a recession could still leave agriculture and mining (including drilling) in positive territory as a result of supply and demand imbalances discussed at length elsewhere.

Conclusions

The non-resource economy will contract somewhat from here and we will see a recession in the next 18 months.

This will have little impact on the resource sector as the demand from China and India has only just begun (even though demand as a result of global growth has probably peaked).

Short term interest rates in Australia will go higher than everyone expects.

A synchronized slowdown in the UK, Australia, New Zealand and the US will reduce global commodity demand and will reduce prices but not from today's levels, instead there will be 1 year or so of additional demand at this peak before prices drop in a globally synchronized recession. Prices will not drop to levels seen in 2000 because China and Indian growth are the backstop.

posted by Neil  # 2:49 AM