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The onset of the New Year has failed to lessen investor uncertainty concerning the ongoing economic recovery and equities uptrend. Based on a recent economic commentary by the Cleveland Fed economist Joseph Haubrich, we have used the yield curve as a forecasting tool to try understanding what might happen to the economy in the months to come.

Indeed, since the 80s, a large number of academic studies have suggested that the yield curve is a reliable predictor of recessions: for example, before each of the last seven recessions,including the last one, short term interest rates (3 month T-bill) rose above long term rates (10 year T-bond), producing what economists call yield curve inversion. Although the yield curve has made a poor job in forecasting the magnitude of economic growth, it is a great forecaster of the direction of the economy.

More generally, the rule of thumb is that an inverted yield curve indicates a recession in about a year, a flat curve indicates weak growth and a steep curve indicates sharp growth. The recent slope of the yield curve offers ample evidence that the pace of recovery is unlikely to moderate in 2010. Between December 2009 and early January 2010 the slope of the yield curve increased to almost 380bp, up from November’s 335bp and from October’s 332bp.

The outcome of past academic studies also enables us to calculate the likelihood of a recession in the 12 months ahead using the steepness of the yield curve.

In particular, we are using a probit model, which exploits the normal distribution to convert the value of a measure of the yield curve steepness into a probability of recession one year ahead.

The model developed by the NY Fed economists Estrella and Trubin (“The yield curve as a leading indicator: some practical issues”) suggests that the current yield spread is in line with a 0% chance of recession in the coming 12 months.

Another meaningful probit model was developed by the Fed economist Jonathan Wright in the paper “The yield curve and predicting recessions”. This model uses both the yield spread and the level of the Fed fund rate to determine the probability of recession. According to Wright calculations, the predictive power is higher than that of the yield spread alone. Even under this model, the chances of another recession in the subsequent 12 months appear to be close to 0%.

Are we sure that a recession will not occur in 2010? An argument against taking too much comfort from the positive slope of the yield curve was provided by Paul Krugman, who had previously predicted a 30/40% chance of a recession materializing in 2010. In his NY Times blog, Krugman said that, given that the Federal Reserve cannot cut rates from here, long-term rates must be higher than short-term rates because they are like an option: short rates might move up but they cannot go down. Krugman reinforced his view highlighting that in Japan the yield curve was positively sloped all the way through the lost decade.

However, unless the US economy experiences a lost decade, as it occurred in Japan - a possibility that we do not rule out but that we consider thin - the yield curve message should be taken seriously. Only signals of a new recessionary phase before the Fed begins to raise rates will bring us to reconsider the yield curve as a forecasting tool. The predictive power of the slope of the yield curve is not limited to the US economy.

In a paper published in 1996 (“Does the term structure predict recessions? The international evidence”) BIS’s economists Bernand and Gerlach highlighted that home country yield curves have predicted recessions in 8 countries.

Hence, based on most recent data, no major developed countries will likely slip into recession in 2010. The steepness of the yield curve also gives us useful indications of the corporate profits outlook. Indeed, a considerable gap between the 10 year T-bond and 2 year T-bill has been usually followed by a sharp increase in corporate profits in the subsequent three years (see chart below).

Obviously, this does not come as a surprise considering the above-mentioned yield curve ability to anticipate economic growth.

Disclosure: I am long the Nasdaq 100

Source: What Is the Yield Spread Telling Us?