THE YIELD CURVE: A GOOD PREDICTOR OF THE ECONOMIC GROWTH RATE?

J. BATA, K. BROCK, M. MADULA, J. MORTLOCK, M. MWANSA, K. NAKAZWE, L. SHOSHA, K. SIBISIBI, K. SPURWAY and M. ZOKWE 1. FINANCIAL ECONOMICS ESSAY

a) A brief overview of yield curve theory In finance, the yield curve can be understood as a graphical illustration of the interest rates (or the cost of borrowing) of bonds that are characterised as having equal credit quality but varying time to maturity (Investopedia, 2011). The yield curve is therefore a plot of yields on bonds that have different terms to maturity but all have the same tax implication, risk, and liquidity (Mishkin, 2010: 130). The yield curve is said to be the benchmark for other debt that the market may have which includes; amongst others, bank lending rates and mortgage rates (Investopedia, 2011). The yield curve is said to be illustrative of the term structure of various bonds and is a predictive tool that presents itself useful in foreseeing variations in output and economic growth (Mishkin, 2010: 130131). The yield of a debt instrument particularly refers to the overall rate of return that is available for a particular debt instrument. The amount that can be yielded on a particular instrument is dependent on the original face value of the instrument, length of time for which that money is invested, the market interest rate, and the coupon rate. The yield on government bonds is similarly dependant on a number of factors; these include, prevailing and expected interest rates, the inflation rates, the level of money supply and generally the monetary policy that is adopted by the government. By analysing and plotting these yields the yield curve can be used as an important economic tool in analysing bonds and securities to obtain a grounded understanding of economic conditions, financial market conditions and trading opportunities (Gupta, 2010). Another important aspect to consider is the shape of the yield curve. Yield curves may be positively sloped, negatively sloped, or flat in nature. A positively sloped yield curve is said to arise when the long-term interest rates are above the short term interest rates. Conversely, negatively sloped yield curves arise when the short-term interest rates are above the long term interest rates. Finally, when the short term and long term interest rates are the same, then a flat yield curve would be evident. Generally, theory states that, yield curves are almost always expected to be upward sloping. Furthermore, the interest rates of bonds of different maturities are expected to move together. A final note on the shape of the yield curve is that when short-term interest rates are low, the yield curve is likely to be positively sloped and when short-term interest rates are high the yield curve is likely to be inverted (Mishkin, 2010: 130-131). Another explanation of positively sloped yield curves is that longer maturities entail greater risks for the investor. A positive liquidity premium is needed by the market to account for this, since at longer maturities are more exposed to uncertainty and a greater chance of exposure to negative economic shocks that may have adverse effects on the investment. This explanation is dependent on the assumption that the economy experiences more uncertainties in the long term than it does in the short term. This effect

is referred to as the liquidity spread. If the market conditions are expected to be volatile in the longer term, even if a decline in interest rates are expected, a significant positive risk premium is able to influence the spread and cause an increasing yield (Mishkin, 2010: 132-137). The next important element of yield curve analysis to consider is the expectations theory. This theory states that the interest rates on a long-term bond will be equivalent to the mean of the short term interest rates that people expect to exist over the full duration of the long-term bond (Mishkin, 2010: 132). The yield curve is indicative of the expected GDP growth rate. If the yield curve is positively sloped, then it is expected that interest rate would rise. Conversely, if the yield curve has an inverse trend then it is expected that the interest rates will fall. If the yield curve is flat in nature, then it is expected that the interest rates will remain unchanged. Conventionally, it is expected that long-term rates should be greater than short-term rates and thus a positive gap is expected to exist in such a case. With the gap being positive the expectations theory stipulates that interest rates should rise (Mishkin, 2010: 132). b) Recent Trends - Graph of Interest Rates, Yield Curve and GDP in South Africa Figure 1.1: The relationship between the rate on government bond and the 91-day Treasury bill rate
14 12 10 8 6 4 2 0 SAGBOND (long term) 91 t.bill (short term) yield curve

Q4 2001

Q1 2007

Q1 2001

Q3 2002

Q2 2003

Q1 2004

Q4 2004

Q3 2005

Q2 2006

Q4 2007

Q3 2008

Q2 2009

Q1 2010

-2 -4 -6

Figure 1.1 shows the short-term interest rate (91-day Treasury bill) and the long-term interest rate (Government bond). The short-term and long-term interest rates follow a very similar pattern, for example from 2003Q1 to 2006Q1 both interest rates are falling and from 2006Q2 to 2008Q2 the movement of both interest rates is upwards (Shelile, 2006:43). The yield curve is an important determinant of almost all asset prices and economic decision as it determines the amount of money an investor will allocate today on actual payments at all upcoming dates (Gurkaynak, Sack & Wright, 2006:28). Figure 1.1 shows the yield spread which is the difference between the long-term interest rate and the short-

Q4 2010

term rate. The theory of term structure of interest rates explains that during an economic upswing long-term rates are usually higher than the short-term rates. A possible reason is that there is higher risk associated with long-term lending therefore a positive yield curve should be experienced during these periods (Shelile, 2006: 45). It can be seen that from period 2003Q3 to 2006Q2 the long-term rate is above the short-term rate and a positive yield curve is produced; but this is not always the case for example between 2002Q3 and 2003Q3 the short-term rate is above the long-term rate hence the yield curve is below 0% interest, this is know as the inverted yield curve (Shelile, 2006:43). The point where the short-term rate and long-term rate is intersects is where the yield curve produces 0, this is know as flat yield and this can be seen in period 2003Q3. Figure 1.2:

The graph above shows the long and short term interest rate curves (SAGBOND and 91 t.bill, respectively) as well as the subsequently derived yield curve and the GDP curve for the same time period. As will be shown in the following discussion, this graph contains a wealth of knowledge on not only the relationship between the yield curve and GDP, which is the main issue of this paper, but also that between the interest rates and GDP. To begin with, the relationship between the interest rates and GDP shall be analysed. Monetary policy via interest rates effects changes through the short run interest rate. Hence, from the graph we are able to examine the effects of monetary policy on GDP. It is observed how during the period 2003 to 2006, monetary policy was such that the short run interest rate was reduced. This same period saw a rise in GDP as would be expected from theory where reducing interest rates leads to increases in GDP via the increase of investment (as capital is made cheaper) as well as consumption (Howells and Bain, 2008: 199). Conversely, during the following period, 2007 2008, interest rates were raised, via

monetary policy, and GDP decreased which is explained by a fall in spending and investment as borrowing became expensive. The relationship between the yield curve and GDP is brought to light by the apparent similarity in the structures of the 2 curves. The movements of the yield curve seem to be mimicked by the GDP curve, roughly a quarter or 2 later. This is evident from the beginning of the expressed period (2001 Q1) where the yield curve slopes downward and, about a quarter later, the GDP curve follows suit. The same behaviour is observed again when the yield curve rises in 2001 Q2, falls in 2002 Q1, and so on. This provides great predictive possibilities as will be discussed later. What needs to be brought up at this time however is what seems to be occurring at the instance of a flat yield i.e. the instance of equal long term and short term interest rates (Irturk, 2006: 9). When 0% (flat) yield is derived GDP growth is expected to be half way through its trend (either halfway up or halfway down). Hence, prediction can be made on when the end of the incumbent trend is, i.e. when a recession will end and a boom begin or vice-versa. In the graph above, however, this point of equal interest rates is observed earlier than halfway through the trend. For example, the flat yield at the end of 2008 Q2 should indicate the half way point of the recession being experienced. The drop in GDP continues after this, however, for a longer time than before it. A possible reason for this is that the transmission mechanism in South Africa from monetary policy to output/GDP is not very fast. Hence, changes in interest rate take a while to be felt in real terms. This does not take away from the predictive nature of this feature of the yield curve. It does however mean that the delay must be taken into account. This information allows us to start drawing conclusions about the predictive ability of the yield curve on economic growth c) Yield curve as a predictor

Over the last few decades, a predictive relationship between the slope of the yield curve and subsequent inflation and real economic activity has been uncovered. A term structure spread is used to predict either subsequent real output growth or future recessions. There are a number of explanations for the relationship between the yield curve (Long term gov bonds-91 TB) and its ability to explain the business cycle (Moolman, 2002). It is a good indicator, as by looking at the yield curve, prior to the recession, the slope of the term structure will become flat or inverted, meaning the yield spread (Gov bonds91 day TB) is declining, so one can therefore predict a recession in the future. Similarly an upward yield curve predicts there will an expansion in the future (Moolman, 2002).One explanation of this phenomena assumes high growth, to a point where most investors are in a general agreement that the country is at its peak in the business cycle and is heading for a slow down or recession in the future. Consumers want to hedge against the recession, so they purchase financial instruments e. g Bonds that will provide payoff during the recession. The increased demand for bonds increases the price of bonds and therefore decreases the yield of the bonds. In order to fund these bond purchases, investors sell their short term assets leading to a decrease in the price of short term assets, and an increase in the yield of the short term assets e. g (91 day TB). If a recession is expected, long term interest rates are expected to fall and short term interest

rates are expected to rise, leading to a declining in the yield spread and ultimately a decrease in GDP (Moolman, 2002). The yield curves predictive power can also be explained by assuming that financial instruments with different maturities are perfect substitutes, so an investor will be indifferent in investing in one long term bond or several consecutive short terms TB as long as their expected returns are equal. This means that the long term yield will be the average of the current and future short term yields (Moolman, 2002). Assume that central bank increases short term rates; economic agents will view this as a temporary shock and will expect future short term rates to rise by less than the current change in interest rates. Due to being perfect substitutes and due to expectation the long term rate will rise by less than the current short rate. This leads to a flatter or even an inverted yield curve. Since monetary policy has a lag of one to two years, the tightening in growth will cause a reduction of future economic activity and increase the probability of a recession. Therefore prior to a recession the yield spread will decline (Moolman, 2002). d) Recent Empirical Evidence in South Africa A number of studies provide empirical evidence that the term structure has predictive power on economic activity. The measures of real economic activity for which predictive power have been found include GNP and GDP growth, growth in industrial production, consumption, and investment. To predict these series, analysts have relied on relatively standard regression equations, taking care to deal with some important econometric issues (Shelile, 2007:19). There is a substantial amount of evidence that suggests that there is a relationship between the slope of the yield curve and real economic activity. Nel (1996) found favourable evidence of the predictive ability of the term structure of interest rates for South Africa. The period under investigation in this study was the twenty years from 1974:1-1993:4. This was subdivided into the period of approximately 10 years prior to the gradual implementation of the new monetary control measures in South Africa during the 1980s, and the period thereafter. In this study only one measure of the slope of the yield curve was computed, that is, the difference between the rates on long-term government bonds 10-years-and-over and the 3-month Treasury bill. Both rates were quarterly averages, and Nel used a simple econometric model to regress the annual growth in real GDP on the yield curve. He concluded that the slope of the yield curve is positively related to the growth in real GDP in South Africa, which suggests that the term structure does contain information about economic activity (Shelile, 2007:19). The more recent study of the term structure of interest rate in South Africa is Moolman (Shelile, 2007:19). In this work the probit model was used to evaluate the term structure as a predictor of turning points in the South African business cycle. Quarterly data for the period 1979:1-2001:3 was used in the empirical analysis. Consistent with Nel (1996), the yield spread was defined as the yield difference between 10-year bonds and 3month bankers acceptances. Moolman (2002) indicated that the term structure successfully predicts the turning points of the business cycle (Shelile, 2007:19). Shelile (2007:4) did a study of yield curve ability to predict economic growth; he used what he claims to be the most effective model; Generalised Method of Moment (GMM). Data used by this respective paper was 91-days Treasury bill, long-term government bond, real GDP growth all obtained from South African Reserve Bank (SARB). For

multi-variable model, Shelile added M3 and all share index and data were obtained from Quoin Institute. The period under investigation was 1970 to 2004 quarterly data. Shelile stated that conclusion for this depends on the prevailing monetary policy (whether regulated or deregulated). The conclusion drawn based on the data was that the slope of the yield curve is positively related to the GDP growth in South Africa. Mehl (2008:683) studied yield curve ability to predict economic growth and inflation using dynamic factor model and general equilibrium model of a monetary economy. Data for slope of the yield curve were taken from the Bank for International Settlements, Bloomberg, and Global Financial Data. In his study, the slope of the yield curve was defined as the difference between the yield on the 5-years domestic government bond in local currency and that on the 3-month Treasury bill in local currency. The data for South Africa proved to be significant in that the slope of the yield curve is positively related to the GDP growth in South Africa Mehl (2008:705). e) Monetary Policy and the Yield Curve

In South Africa monetary policy decisions are in practice taken after deliberations by the SARB Monetary Policy Committee (MPC) (Shelile, 2007: 33). The operation of the main monetary policy instrument, the setting of the level of the repurchase rate remains the prerogative of the Governor, in consultation with deputy governors and other members of the MPC. Monetary policy is conducted mainly through interest rate controls, liquid asset requirements, and cash reserve requirements (Shelile, 2007: 35). These measures are aimed at controlling the growth in monetary aggregates with a view of curbing inflation. However stringent interest polices gives little room for financial market development. Hence, it was undesirable for the MPC to increase the interest rates. According to Shelile (2007: 42) a tightening of monetary policy usually means a rise in short-term interest rates, typically intended to lead to a reduction in inflationary pressures. The expectations are that when those inflationary pressures subside, policy easing will follow. Expected future short-term rates are important determinants of current long-term rates. Thus, long-term rates tend to respond to a contractionary monetary policy by increasing. The short-term rates increase by the same magnitude as contractionary monetary policy, which will induce less spending in some parts of the economy; this will lead to a decline in economic activity, hence a decline in future output growth as a shown in the figure below (Shelile, 2007: 42). Central banks normally operate on the short end of the yield curve, and are able to influence the short-term interest rates directly. If the South African Reserve Bank (SARB) increases short-term interest rate (REPO rate), the spread between the short-term interest rates and long-term interest rates declines (Shelile, 2007: 40). This signifies that markets expect inflation to decline in the future and short-term interest rates to revert to normality.

Graph of Interest Rates and Yield Curve

14

Interest Rates

12 10 8

6
SAGBOND (long term) 4 2 0 -2 -4 -6 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 91 t.bill (short term) yield curve

During the periods when the South African monetary policy was highly regulated it was shown in the Figure that the yield spread does not mirror the changes in GDP growth curve closely (Shelile, 2007: 44). During the periods of monetary policy deregulation the yield spread closely mirrors the changes in GDP growth (Shelile, 2007: 44). This implies therefore that in South Africa the prevailing monetary policy may affect the predictive ability of the term spread on economic activity. f) Relationship between Monetary Policy, the Yield Curve and Economic Activity

Our main objective is to examine the effects of the monetary policy regime changes on the predictive ability of the term spread, and its generally predictive capabilities in South Africa. Although numerous empirical and academic studies conclude that the short-term rates are unstable and therefore an unsuitable base for economic predictions; the yield curve is still widely accepted as a predictor of economic activity (Stock and Watson, 2998; in Maitland, 2002: 132). Economists and investors believe that the shape of the yield curve reflects the markets future expectation and its slope can be classified as upward sloping (Q3 2008 Q3 2009), flat (Q3 2003 Q4 2003)or downward sloping (Q4 2001 Q2 2002) as evidenced in figure 1 (Mishkin, 2001:137). In using the yield curve as a predictor of economic activity the effects of monetary policy on its predictive ability must also be considered. Under policy deregulation the term spread predicts economic activity better and explanations for this phenomenon are highlighted in Moolman (2005) based on the cyclical asymmetry characteristic of business cycles. Moolman (2005) further posits that recent developments such as the MPC decision to keep the repurchase rate unchanged at 5, 5 per cent per annum, against the backdrop of the improving growth outlook; predict a seemingly sustained recovery in

domestic expenditure and expectations that inflation would remain within the medium target range during the assessed period. Moreover, the two main reasons why the yield curve is a good predictor in emerging markets such as South Africa are: 1. Liquidity Premium Theory Applications Investors seek to hedge against economic downturns and recession in future by purchasing financial instruments (long-term) that will retain wealth during the downturn. Therefore selling their short-term assets, putting downward pressure on the short-term asset prices and raising the yield on these assets. In short, if a recession is expected in future, long-term interest rates will fall and short-term interest rates will rise; making the slope of the yield curve flatter or inverted (depending on the extent to which short term rates are expected to rise). The inverse occurs when an expansion is expected; leading to an upward sloping yield curve. This is clearly evidenced by the upward sloping SA yield curve from Q3 2008, followed by rising GDP Q2 2009. At the moment the yield curve is upward-sloping, thus the short-term interest rates, such as 91-day Treasury bill rate, are below the long-term rates, keeping them stable would perpetuate the current shape keeping it positive. The MPC has decided to keep the repurchase rate unchanged at 5,5 per cent per annum for the time being, against the backdrop of the improving growth outlook, a seemingly sustained recovery in domestic expenditure and expectations that inflation would remain within the medium target range during the assessed period. The decision was reached despite prevailing risks emanating from global commodity price hikes, particularly oil and food prices, and domestic costpush factors, most notably the upcoming wage settlements. 2. Expectations Theory Applications Since monetary policy has an effect on economic activity, with a lag of one to two years, a tightening of monetary policy is usually followed by expectations of future short term rates rising by less than the current change in short term rates (Moolman, 2005). The use of this characteristic of the yield curve has proved to be a good predictor of the expectations held by investors and market actors; towards business cycle movements. This relationship was initially confirmed by Estrella and Hardouvelis (1991) and later by Barnard and Gerlach (1996) and showed that 'domestic term spreads are statistically significant in explaining business cycles turning points...' and that it is the most accurate in these predictions (Moolman, 2005: 3). g) Using the Yield Curve as a Predictor of Economic Activity

As observable on figure 1.2 and confirmed in the European Central Bank Working Paper (2006) for South Africa: 'further to a 100 basis points steepening observed a year and a half ago, inflation is expected to accelerate around 60 basis points a year ahead, against 2 percentage point for industrial g production growth'. Conquering with the views of the work by the ECB, a priori expectations and Nel (1996; in Moolman, 2005) we can see from figure 1 that the term spread is indeed a significant predictor of up to six months (to four quarters) in advance, of GDP movements and whether the economy will enter a recession or growth phase. What we can extrapolate from our current yield curve is that

GDP growth should average in the 3.3 4.1% bracket, inflation should average around 5% in the next year; and furthermore that there should be an intercept of the yield curve and the GDP schedule at some point within the next 18 months; a signal that there is going to be a turning point in the business cycle in the not so distant future. Figure 1.3
Percentage change

Graph of Yield curve and GDP

h) Conclusion Drawing from the main points from the essay with the use of data and analysis of trends, empirical evidence; it is safe to conclude that there is a strong relationship between the yield curve and real economic growth rate. As shown the yield curve can be used to predict the interest rates in South Africa, by evaluating the recent trades of the long term and short term interest rates. This makes the yield curve a good predictor of economic growth. REFERENCES BERNARD, H. and GERLACH, S. (1996). Does the Term Structure Predict Recession> The International Evidence. Working Paper No. 37. Bank for International Settlements: Basle. ESTRELLA, A. and HARDOUVELIS, G. A. (1991). The Term Structure as a Predictor of Real Economic Activity. The Journal of Finance 46: 555-575.

EUROPEAN CENTRAL BANK. (2006). The Yield Curve as a Predictor and Emerging Economies. Working Paper Series No 691/ November 2006. ECB: Frankfurt. GUPTA, A. (2010). Yield helps determine the worth of a debt instrument. The Economic Times. [Online]. Available: http://articles.economictimes.indiatimes.com/2010-1219/news/27601342_1_bond-price-coupon-rate-interest-rates GURKAYNAK, R., S., SACK, B. and WRIGHT, J., H. (2006). The U.S. Treasury Yield Curve: 1961 to the Present. Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. Working Paper. 28:1-42.

HOWELLS, P. and BAIN, K. (2008). The economics of money banking and finance: A European text (4e). England: Pearson.
INVESTOPEDIA. (2011). Yield Curve. [Online]. Available: http://www.investopedia.com/terms/y/yieldcurve.asp [Accessed 20 April 2011].

IRTURK, A. U. (2006). Term Structure of Interest Rates. Unpublished Masters thesis. California: Department of Economics, University of California.
MAITLAND, A.J. (2005). Interpolating the South African Yield Curve Using PrincipalComponents Analysis: A Descriptive Approach. The South African Actuarial Journal 2(1): 129-145. MEHL, A., (2008). The Yield Curve as a Predictor and Emerging economies. Open Economic Review 20: 683-716. MISHKIN, F.S. (2010). The Economics of Money, Banking and Financial Markets (9e). Boston: Pearson. MOOLMAN, E. (2002) The Term Structure as a Predictor of Recessions. Studies in Economics and Econometrics 26(1): 43:52 SHELILE, T., (2007). The Term Structure of Interest Rates and Economic Activity in South Africa. Master thesis: Commerce and Financial Markets, Department of Economics and Economic History, Rhodes University, Grahamstown, South Africa