Can the Term Spread Predict Output Growth and Recessions? A Survey of the Literature

Abstract

This article surveys recent research on the usefulness of the term spread (i.e., the difference between the yields on long-term and short-term Treasury securities) for predicting changes in economic activity. Most studies use linear regression techniques to forecast changes in output or dichotomous choice models to forecast recessions. Others use time-varying parameter models, such as Markov-switching models and smooth transition models, to account for structural changes or other nonlinearities. Many studies find that the term spread predicts output growth and recessions up to one year in advance, but several also find its usefulness varies across countries and over time. In particular, many studies find that the ability of the term spread to forecast output growth has diminished in recent years, although it remains a reliable predictor of recessions. (JEL C53, E37, E43)

MICA-BBVA: a factor model of economic and financial indicators for short-term GDP forecasting

“…1, which plots a summary of the highest log likelihood associated to different combinations of lead time periods for financial indicators, we find that the maximum of the likelihood function is achieved when the slope of the yield curve is allowed to lead the common factor by 9 months, and the rest of financial variables (credit, the spread and the mortgage rate minus 12-month Treasury bill rate) enter contemporaneously. 15 In fact, this result goes in line with Wheelock and Wohar (2009) who find that the contemporaneous correlation between GDP growth and the slope of the yield curve is not statistically different from zero for the US, the UK and Germany, whereas the correlation with the slope lagged from one to six quarters are uniformly positive and statistically significant.…”

“…Given its novelty in this type of analysis, the treatment of financial indicators in the dynamic factor model deserves special attention. Wheelock and Wohar (2009) point out that financial variables are usually leading rather than coincident indicators of the economic activity. They argue that the higher the slope of the yield curve, the higher the growth rate which is expected to be observed in future quarters.…”

“…The first contribution to the previous literature is the use of financial time series as leading indicators of output growth, in a factor model that accounts for asynchronous co-movements between the financial and the real activity indicators. According to the excellent review of the literature by Wheelock and Wohar (2009), it still remains an open question whether financial series help in forecasting growth. Although many studies find that financial indicators are useful for forecasting output growth at about one-year horizons, they also acknowledge that the ability of some financial series (such as the slope of the yield curve) to forecast output growth has declined since the mid-1980s.…”

How useful is the yield spread as a predictor of growth in Australia?

“…There is ample evidence suggesting that changes of monetary regime may render the spreadgrowth nexus unstable over time (Wheelock and Wohar, 2009 any, the GFC may have had on the relationship.…”

Debt and Macroeconomic Stability: An Overview of the Literature and Some Empirics

“…Ex-post examinations of forecasting performance have tended to highlight that simple indicators can perform well in predicting growth, but the best indicator changes over time (Banerjee and Macellino, 2006;Stock and Watson, 2001). However, in a number of studies, the yield curve appears to contain useful information in signalling future recessions (Estrella, Rodrigues and Schich, 2003;Rudebusch andWilliams, 2009, Wheelock andWohar, 2009). …”