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The yield curve and predicting recessions

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Author Info
Jonathan H. Wright

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Abstract

The slope of the Treasury yield curve has often been cited as a leading economic indicator, with inversion of the curve being thought of as a harbinger of a recession. In this paper, I consider a number of probit models using the yield curve to forecast recessions. Models that use both the level of the federal funds rate and the term spread give better in-sample fit, and better out-of-sample predictive performance, than models with the term spread alone. There is some evidence that controlling for a term premium proxy as well may also help. I discuss the implications of the current shape of the yield curve in the light of these results, and report results of some tests for structural stability and an evaluation of out-of-sample predictive performance.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2006-07.

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Date of creation: 2006
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Handle: RePEc:fip:fedgfe:2006-07

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Related research
Keywords: Economic indicators ; Economic forecasting ; Interest rates;

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Arturo Estrella & Frederic S. Mishkin, 1996. "The yield curve as a predictor of U.S. recessions," Current Issues in Economics and Finance, Federal Reserve Bank of New York, issue Jun. [Downloadable!]
  2. James H. Stock & Mark W. Watson, 1992. "A Procedure for Predicting Recessions With Leading Indicators: Econometric Issues and Recent Experience," NBER Working Papers 4014, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  3. John H. Cochrane & Monika Piazzesi, 2002. "Bond Risk Premia," NBER Working Papers 9178, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Poirier, Dale J & Ruud, Paul A, 1988. "Probit with Dependent Observations," Review of Economic Studies, Blackwell Publishing, vol. 55(4), pages 593-614, October. [Downloadable!] (restricted)
  5. Estrella, Arturo & Hardouvelis, Gikas A, 1991. " The Term Structure as a Predictor of Real Economic Activity," Journal of Finance, American Finance Association, vol. 46(2), pages 555-76, June. [Downloadable!] (restricted)
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  6. Arturo Estrella & Anthony P. Rodrigues, 1998. "Consistent covariance matrix estimation in probit models with autocorrelated errors," Staff Reports 39, Federal Reserve Bank of New York. [Downloadable!]
  7. Arturo Estrella & Anthony P. Rodrigues & Sebastian Schich, 2003. "How Stable is the Predictive Power of the Yield Curve? Evidence from Germany and the United States," The Review of Economics and Statistics, MIT Press, vol. 85(3), pages 629-644, 07. [Downloadable!] (restricted)
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  8. Andrew Ang & Monika Piazzesi & Min Wei, 2003. "What does the yield curve tell us about GDP growth?," Proceedings, Federal Reserve Bank of San Francisco, issue Mar. [Downloadable!]
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  9. Campbell, John Y & Shiller, Robert J, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Review of Economic Studies, Blackwell Publishing, vol. 58(3), pages 495-514, May. [Downloadable!] (restricted)
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  10. Don H. Kim & Jonathan H. Wright, 2005. "An arbitrage-free three-factor term structure model and the recent behavior of long-term yields and distant-horizon forward rates," Finance and Economics Discussion Series 2005-33, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  11. Hamilton, James D & Kim, Dong Heon, 2002. "A Reexamination of the Predictability of Economic Activity Using the Yield Spread," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(2), pages 340-60, May.
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  12. Arturo Estrella & Frederic S. Mishkin, 1999. "Predicting U.S. Recessions: Financial Variables as Leading Indicators," NBER Working Papers 5379, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  13. James H. Stock & Mark W. Watson, 1989. "New Indexes of Coincident and Leading Economic Indicators," NBER Chapters, in: NBER Macroeconomics Annual 1989, Volume 4, pages 351-409 National Bureau of Economic Research, Inc. [Downloadable!]
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  14. Raffaella Giacomini & Barbara Rossi, 2006. "How Stable is the Forecasting Performance of the Yield Curve for Output Growth?," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 68(s1), pages 783-795, December. [Downloadable!] (restricted)
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  15. Gourieroux Christian & Monfort Alain & Trognon A, 1982. "Estimation and test in probit models with serial correlation," CEPREMAP Working Papers (Couverture Orange) 8220, CEPREMAP.
  16. Fama, Eugene F & Bliss, Robert R, 1987. "The Information in Long-Maturity Forward Rates," American Economic Review, American Economic Association, vol. 77(4), pages 680-92, September. [Downloadable!] (restricted)
  17. Andrews, Donald W K, 1993. "Tests for Parameter Instability and Structural Change with Unknown Change Point," Econometrica, Econometric Society, vol. 61(4), pages 821-56, July. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Modena, Matteo, 2008. "Yield curve, time varying term premia, and business cycle fluctuations," MPRA Paper 8873, University Library of Munich, Germany. [Downloadable!]
  2. Thomas B. King & Andrew T. Levin & Roberto Perli, 2007. "Financial market perceptions of recession risk," Finance and Economics Discussion Series 2007-57, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  3. Glenn D. Rudebusch & John C. Williams, 2007. "Forecasting recessions: the puzzle of the enduring power of the yield curve," Working Paper Series 2007-16, Federal Reserve Bank of San Francisco. [Downloadable!]
  4. Glenn D. Rudebusch & Brian P. Sack & Eric T. Swanson, 2007. "Macroeconomic implications of changes in the term premium," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 241-270. [Downloadable!]
    Other versions:
  5. Jacob Poke & Graeme Wells, 2007. "The Term Spread And Gdp Growth In Australia," CAMA Working Papers 2007-27, Australian National University, Centre for Applied Macroeconomic Analysis. [Downloadable!]
    Other versions:
  6. Mateus A. Feitosa & Benjamin M. Tabak, 2007. "Predictability Of Economic Activity Using Yield Spreads: The Case Of Brazil," Anais do XXXV Encontro Nacional de Economia [Proceedings of the 35th Brazilian Economics Meeting] 029, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics]. [Downloadable!]
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