Interest Rate Spread

---

The following perspective is excerpted from a speech given by William Poole, the President of the Federal Reserve Bank of St. Louis. It was part of the Central Bank Series at the Global Interdependence Center of the Federal Reserve Bank of Philadelphia on May 18, 2006. In it he discusses the predictive ability of inversions in the interest rate spread:

“Inversion has been much in the news for some months now. Indeed, inversion has made the big time, with William Safire devoting a column in the Sunday New York Times (April 23, 2006) to I.Y.C.—Inverted Yield Curve. By inversion, of course, I’m referring to a situation in which short-term interest rates are higher than long-term interest rates. When I agreed to speak on this topic last fall, market concern over I.Y.C. was running high. The FOMC had been providing guidance that it would probably continue to raise the target federal funds rate; given the level of the 10-year Treasury yield in the 4¼ to 4½ percent range, market observers expected that the funds rate would soon be above the 10-year rate. Recession concerns were widely discussed, because in the past I.Y.C. has often been associated with recession. Moreover, many found it odd that until last month the monthly average 10-year bond rate was actually lower than it had been in June 2004 when the FOMC began to raise the fed funds rate target. It seemed a puzzle that the 10-year rate was actually the same in March 2006 as it had been in June 2004 even though the FOMC had raised the target fed funds rate from 1 percent to 4¾ percent. Now that the 10-year rate has risen by another 50-75 basis points, to about 5.15 percent, apparently everyone feels a lot better!

“An important problem with much I.Y.C. commentary is that it involves a search for patterns in the data without an effort to understand the economics that might lie behind the patterns. Understanding why observations follow a particular pattern is essential to judging whether a pattern is likely to persist or apply to today’s situation. Economists have been studying the term structure of interest rates for a long time. The first proposition is that a long interest rate reflects investor expectations of the average short rate over the horizon of the long rate. Thus, today’s 1-year rate reflects expectations of the next 52 one-week rates; today’s 10-year rate reflects expectations of the next 10 one-year rates. I deliberately used the phrase “reflects expectations” because there is ample evidence that a long rate is not always equal to the appropriately weighted average of the short rates over the horizon of the long rate.

Most of the time, long rates are somewhat above short rates. Over the past 50 years, for example, the 10-year Treasury rate has averaged about 90 basis points above the federal funds rate. The difference between the long rate and average expected short rate over the horizon of the long security is called the “term premium.” On average, the term premium is positive, but theory does not predict any particular relationship. The term premium is thought to arise from investor attitudes toward risk. Capital values fluctuate more the longer a bond’s maturity, and investors averse to capital risk therefore prefer shorter maturities. On the other hand, interest income fluctuates more for a series of investments in short-term bonds than for a long-term bond; investors averse to income instability therefore prefer longer-term bonds. The balance of investors with different and changing attitudes toward risk changes over time, and other conditions may also change. Thus, there is no reason to expect that term premiums will be constant, and they aren’t. Given that investor expectations about future short rates are not directly observable, and their preferences that create term premiums are not directly observable either, there is no absolutely reliable way to disentangle changing interest-rate expectations from changing term premiums.”

http://stlouisfed.org/news/speeches/2006/05_18_06.htm

---

The following is excerpted from a press release by the Conference Board, a private organization that compiles The Index of Leading Economic Indicators. Note that the interest rate spread is one of the components of the Index. The press release is dated September 22, 2005:

"The Conference Board announced today that the U.S. leading index decreased 0.2 percent, the coincident index increased 0.2 percent and the lagging index decreased 0.1 percent in August.

The leading index decreased slightly in August, its second consecutive fall. As actual and revised data for the manufacturing new orders components became available, July's slight increase was revised down to a small decrease and there were small downward revisions to the previous months. In August, the main negative contributor to the leading index was the index of consumer expectations. The strengths and weaknesses in the leading indicators have been somewhat balanced but much of the strength in the leading index in recent months comes from the interest rate spread. (The economic effects of Hurricane Katrina are not reflected in the August values.)

"The leading index increased rapidly through the first quarter of 2004, and although it continues to rise, its growth has slowed steadily through the first half of 2005. The growth rate of the leading index has slowed down from a peak growth of about 10.0 percent at the end of 2003, and it is now fluctuating in the 0.5 to 1.5 percent annual rate range in recent months. At the same time, the growth rate of real GDP has slowed to a 3.3 percent annual rate in the second quarter of 2005 down from a 4.3 percent rate in the first quarter of 2004. The behavior of the leading index (pre-Hurricane Katrina) is consistent with the economy continuing to expand more moderately in the near term.

Leading Indicators. Five of the ten indicators that make up the leading index increased in August. The positive contributors - beginning with the largest positive contributor - were interest rate spread, manufacturers' new orders for nondefense capital goods*, manufacturers' new orders for consumer goods and materials*, real money supply*, and stock prices. The negative contributors - beginning with the largest negative contributor - were index of consumer expectations, vendor performance and building permits. The average weekly manufacturing hours and average weekly initial claims for unemployment insurance (inverted) held steady in August."

http://www.conference-board.org/economics/bci/pressRelease_output.cfm?cid=1

---

The following is excerpted from a speech given by Federal Reserve Vice Chairman Roger W. Ferguson, Jr. to the Financial Stability Forum meeting of the Fed in Washington, DC on September 24, 2005. In it he discusses how recent events in the Gulf states may effect interest rates through higher inflation:

"The FSF noted that economic and financial conditions in the last six months had remained generally benign, having weathered a number of challenges. However, members pointed to the potential impact of higher oil and gas prices on near term prospects for growth and inflation, a factor exacerbated by Hurricane Katrina. Members also pointed to a number of continuing developments that could over time lead to strains in financial markets. These included low levels of risk premia and long-term interest rates, the ongoing search for yield, increased exposures to complex and illiquid products, rising household sector indebtedness, and persistent and growing external and fiscal imbalances.

"Considering the potential challenges these developments imply, many markets may perhaps be underpricing risks going forward. Events or policy mistakes that heighten perception of risks could significantly alter current conditions. In this regard, a resurgence in inflation could alter expectations about the path of short-term interest rates. Signs that higher oil prices are weakening growth, along with the maturing of the credit cycle, could alter perceptions about credit quality and widen credit spreads. Finally, rising oil prices may be troublesome for some emerging market economies."

http://www.federalreserve.gov/boarddocs/speeches/2005/20050924/default.htm

---

The following quote comes from an article written by Michael Dotsey in the summer 1998 issue of the Federal Reserve Bank of Richmond Economic Quarterly, entitled "The Predictive Content of the Interest Rate Term Spread for Future Economic Growth". In it he reviews some of the recent economic literature on the interest rate spread (also known as the yield spread or yield curve):

"Estrella and Mishkin (1998), for example, using data over the period 1959:1 to 1995:1, show that the spread between the yield on the ten-year and three-month Treasury securities is the best out-of-sample predictor of the probability of a recession occurring in the next four quarters. For shorter horizons, they find that adding movements in various stock price indexes improves forecast accuracy. Dueker (1997) also finds that the yield spread is a relatively good in-sample predictor of recessions. He adds a lagged-state-of-the-economy variable and finds that it helps his model predict the severity and duration of big recessions; but as in other studies, he finds that milder recessions are harder to predict."

Dueker, Michael J. "Strengthening the Case for the Yield Curve as a Predictor of U.S. Recessions," Federal Reserve Bank of St. Louis Review, vol. 79 (March/April 1997), pp. 41-51.

Estrella, Arturo, and Frederic S. Mishkin. "Predicting U.S. Recessions: Financial Variables as Leading Indicators," Review of Economics and Statistics, vol. 80 (February 1998), pp. 45-61.

http://www.rich.frb.org/eq/pdfs/summer1998/dotsey.pdf