Using the yield spread to forecast recessions and recoveries

he yield spread suggests the economy will remain weak throughout 2013. The good news: no double dip recession is in the cards. The yield spread increased slightly in January 2013. This follows a bumpy trend up from July 2012, its lowest point since the recession.

The consistently low yield spread suggests mortgage interest rates are not priced for expansion. This is further observed in the continued wide spread between the 30-year mortgage and the 10-year Treasury note rates.

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Chart last updated 2/7/2013

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Data courtesy of the Federal Reserve Bank of St. Louis

Confidence about the year to come

To you stalwart members of the real estate profession who weathered the storm of theGreat Recession, a gift: the ability to forecast the probability of future recessions and rebounds, one year forward. This famed crystal ball is the yield curve spread, simply called the yield spread.

Don’t let the name yield spread put you off. It is not related to the deceptive yield spread premium (YSP) kickback paid by mortgage lenders.

The yield spread reflects economic conditions as interpreted by bond market investors and Fed economists. To use the yield spread, all the layperson has to do is locate and understand what the current yield spread margin imports.

The long-term market rate

The yield spread figure is the difference between two key interest rates:

  • the 10-year Treasury note (T-note) rate (or long-term rate) set by bond market investors; and
  • the 3-month Treasury bill rate (or short-term rate) set by the Federal Reserve (the Fed).

To make a profit on their long-term investments, bond market investors take into account how the Fed’s monetary policy will impact future markets. These millions of private individual forecasts of future economic conditions are translated into a ready gauge for determining future market conditions.

Their considerations encompass two discrete elements:

  • the perceived future rate of inflation, called the inflation risk premium, a figure built into the 10-year (T-note) rate; and
  • the desired fixed rate of return on the investment in excess of the future rate of inflation, called the real rate of earnings.

The short-term market rate

The second piece of information needed to calculate the yield spread is the interest rate on the 3-month Treasury bill. This interest rate is managed by the Fed as the base price of short-term borrowing.

The Fed has direct control over this short-term rate through its Federal Funds Rate. The Fed can:

  • lower interest rates and stimulate economic growth to stave off deflation and economic stagnation; or
  • raise interest rates and slow economic growth to fight inflation and excess demands for labor.

Collectively, the Fed’s use of short-term interest rates and other infusions and withdrawals of dollars to control the economy is known as monetary policy.

Interplay between the treasury rates = the yield spread

Calculating the yield spread is simply a matter of subtracting the 3-month T-bill rate from the 10-year T-note rate.

Generally, a low or declining yield spread indicates a less vigorous economy one year forward. This declining yield spread is a result of bond market investors seeing less future growth resulting from the Fed’s short-term rate activity.

On the flip-side of an economic cycle, a higher or rising yield spread indicates a more vigorous future economy. While good for bond market investors whose actions are full-speed-ahead for profit, a too-high yield spread (and its resulting boom) poses a danger of inflation. When this occurs, the Fed acts to curtail the growth of future jobs and stabilize consumer prices by raising short-term rates.

An over-correction can potentially send the yield spread into low or negative levels. When the yield spread goes negative, or inverts, a recession follows 12 months later.

A yield spread inversion is the result of:

  • the bond market forecasting a future downturn in the economy; and/or
  • the Fed raising short-term interest rates to correct inflation or loose market conditions.

Sometimes even a near-inversion is enough to signal a recession.

That crossover moment gives the real estate broker and agent another signal to adjust their conduct. At the crossover, agents can expect a reduced volume in sales (which will already be slipping), lending and leasing one year forward. Then, in another 12 months, there will be a drop in prices, loan rates and rents.

Reading the chart and current trends

In the above chart:

  • the blue line tracks the yield spread from January 1954 through today.
  • The green line represents the point for which the probability of recession begins, as assigned by Fed economists. Yield spreads smaller than 1.21% predict successively greater probabilities of recessions one year forward.
  • The orange line on the chart represents zero. The yield spread dips below zerowhen the short-term rate rises above the long-term rate. This is the inversion point.
  • Vertical gray bars represent recessions.

In November 2012, the yield spread was +1.56%, the difference between the 3-month rate (0.09%) and the 10-year rate (1.65%) on Treasuries.

Thus, the likelihood of a decline in general business and real estate activities over the next 12 months —halfway into 2013 — is less than 5%. No chance of a recessionary downward trend remains before late 2013.

This positive forecast sent by the November 2012 yield spread is in sharp contrast with the negative yield spread of -0.205% during the last half of 2006.

The negative spread in late 2006 predicted a 40% chance of a recession to take hold one year forward, around the end of 2007. Then in December 2007, we formally entered the recession from which we are now emerging. Each time since 1960 that the yield spread went negative we were in a recession approximately 12 months later.

Fed efforts to prevent a recession

The Fed is watching the yield spread going into 2013, while continuing to keep short-term rates low (essentially zero). Their objective now is to create an environment ripe for consumer and asset (property) price inflation.

In late 2012, the Fed began a third round of quantitative easing (QE3) to improve the job market. As part of this effort, it vowed to keep short-term interest rates low until 2015. Specifically, the Fed intends to hold rates at essentially zero until the job market has fully recovered. They want to induce a degree more of inflation more than is now present.

Thus, the 3-month rate will remain low for the next three years at least. As a result of the bond market rates, the yield spread will remain above its recession-threshold of 1.21% until the Fed increases short-term rates.

Real estate’s stake

Real estate was a key player contributing to the excesses that brought about the recentGreat Recession and the financial crisis. The yield spread was clearly decreasing in the years prior to the implosion of the real estate bubble.

The Fed’s concerted effort to raise short-term rates to lean against the excesses began mid-2004. However, it came too little too late, and only after allowing the market to go hog-wild for too long — an observation derived from hindsight.

Now, the collective efforts of in-the-know real estate professionals will nurse the real estate market back to health. Going forward, more and more brokers and agents need to understand the workings of the yield spread as a gauge of the economy’s direction for the coming 12 months.

Only then, with this insight, will the industry-wide frenzy to over-build, over-price and over-sell be tempered. The steady direction taken by the level-headed professionals within the real estate industry will be the redeeming factor.

Brokers and agents who track the yield spread will be given the foresight to shift their advice and spending routines before the changes in the market actually occur. In doing so they will seek out recession-proof niches of real estate (such as real estate owned (REO) sales, or property management) in which to weather the storm.

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