What Yield Spreads Tell Us About Economic Health

How to Use Yield Spreads to Gauge Recession Odds

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Most international investors are well aware of the tremendous influence that central bank monetary policy has over equity markets. But, beyond trying to predict monetary policy, investors can look at government bond yields to gauge the health of an economy. The spread between long- and short-term bond yields can help investors predict when an economy is growing or at risk of suffering from a recession.

Let's take a closer look at yield spreads, how to calculate them, and strategies for using them when analyzing countries.

What Are Yield Spreads?

Government bonds can provide investors with reliable insights into the health national economies. Short-term bond yields are driven by monetary policy, whereas long-term bond yields are driven by inflation expectations. The difference between long- and short-term bond yields represents the market’s expectations for inflation over the coming years. And, inflation is an excellent predictor of economic growth over time.

Most investors look at the spread between a government’s 30-year bonds and its 3-month yield, since 30-year bonds indicate long-term outlooks and 3-month bonds are influenced directly by monetary policy. These data points can be found on a number of different websites, including financial and economic websites (e.g. TradingEconomics.com or Yahoo!

Finance). The easiest way to visualize the data is to plot only the difference rather than both data sets.

Let’s take a look at an example:

Suppose that the United States’ 30-year bond yields are trading at 2.60 and its 3-month bond yields are trading at 0.374. The yield spread for the United States would therefore be 2.22, which indicates that investors expect about 2.22% inflation over the next 30 years.

In addition to individual countries, investors may also want to look at regional bond yields, such as Eurozone bond yields.

These measures may be easier to calculate when considering the purchase of regional exchange-traded funds (ETFs) that include multiple countries, since investors don’t have to go through and calculate yield spreads for each individual country.

Interpreting the Data

The odds of any single country entering into a recession varies based on a wide array of factors, so there’s no standard yield spread to recession probability chart. However, yield spreads of -1% to -2% are almost always recessionary, while yield spreads of +2% to +1% have relatively low odds of a recession. Some of the most common outliers include countries like Sweden that are more resilient to recessions regardless of yield spreads

Investors should look at the trend in yield spreads for a much more useful indicator. If yields are widening, the odds of a recession are decreasing and the economy is likely improving. If yield spreads are converging, the odds of a recession are increasing and the economy is at risk. Reversals in trends could represent opportunities for investors to invest in or divest from a country that may be reaching an economic turning point.

Let’s take a look at another example:

Using the previous example, let’s assume that U.S. 30-year bond yields fell from 2.60 to 2.00. This would indicate that the market has lowered its expectations for inflation, which would likely be due to the perception of a weakening economy. The yield spread would contract from 2.22 to 1.62, assuming that short-term yields remained steady.

Now, suppose that the Federal Reserve cut interest rates and the 3-month yield dropped to zero. This would cause the yield spread to rise to 1.99 and lower the odds of a recession even though long-term inflation expectations remain muted. Depending on the effectiveness of the interest rate cut, long-term yields could also move higher as inflation expectations rise.

The key takeaway point from this section is that bond yield spreads are designed to show trends rather than absolutes in most cases.

And when looking at absolutes, it’s important to remember that all countries don’t follow the same rules, so a historical context is helpful.

The Bottom Line

Most international investors track central bank predictions as a way to gauge economic health, but existing yield spreads can provide useful data as well. By looking at the difference between long- and short-term bonds, investors can get a feel for where the market anticipates inflation heading over the coming years. Wider spreads tend to predict stronger economic performance, while narrowing spreads might foreshadow weaker performance.