Finance and Economics Discussion Series (FEDS)
August 2018 (Revised March 2019)
The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted Mirror
Eric C. Engstrom, Steven A. Sharpe
Abstract:
The spread between the yield on a 10-year Treasury note and the yield on a shorter maturity security, such as a 2-year Treasury note, is commonly used as an indicator for predicting U.S. recessions. We show that such "long-term spreads" are statistically dominated in models that predict recessions or GDP growth by an economically more intuitive alternative, a "near-term forward spread." The latter can be interpreted as a measure of the market's expectations for the near-term trajectory of conventional monetary policy rates. Its predictive power suggests that, when market participants expected—and priced in—a monetary policy easing over the subsequent year and a half, a recession was quite likely in the offing. We also find that the near-term spread predicts four-quarter GDP growth with greater accuracy than survey consensus forecasts and that it has substantial predictive power for stock returns. Yields on bonds maturing beyond 6-8 quarters are shown to have no added value for forecasting either recessions, GDP growth, or stock returns.
Revised paper: Accessible materials (.zip)
Original paper: PDF | Accessible materials (.zip)
Keywords: Yield Spread, Recession Forecast, Monetary Policy, Policy Path
DOI: https://doi.org/10.17016/FEDS.2018.055r1
PDF: Full Paper