Predicting real growth and the probability of recession in the Euro area using the yield spread
Although the spread has been established as a leading indicator of economic activity, recent studies on US and EU countries have documented, theoretically and empirically, that the term spread-output growth relationship may not be stable over time and it may be subjected to nonlinearities. Using aggregate data for the Euro area over the period 1970:1 - 2000:4, we applied linear regression as well as nonlinear models to examine the predictive accuracy of the term spread-output growth relationship. Our results confirm the ability of the yield curve as a leading indicator. Moreover, significant nonlinearity with respect to time and past annual growth is detected outperforming the linear model in out-of-sample forecasts of one-year-ahead annual growth. Furthermore probit models that use the EMU and US yield spreads are successful in predicting EMU recessions.
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