Predicting European Union recessions in the euro era: The yield curve as a forecasting tool of economic activity

Several studies have established the predictive power of the yield curve, ie: the difference between long and short term bond rates, in terms of real economic activity, for the U.S. and various European countries. In this paper we use data from the European Union (EU15), ranging from 1994:Q1 to 2008:Q3. The seasonally adjusted real GDP is used to extract the long run trend and the cyclical component of the European output, while the European Central Bank’s euro area government benchmark bonds of various maturities are used for the calculation of the yield spreads. We also augment the models tested with non monetary policy variables: the unemployment and a composite European stock price index constructed from the indices of the three major European stock markets of London, Frankfurt and Paris. The methodology employed in the effort to forecast recessions, is a probit model of the inverse cumulative distribution function of the standard distribution, using several formal forecasting evaluation tests. The results show that the yield curve augmented with the composite stock index has significant forecasting power in terms of the EU15 real output.