The Predictive Power of the Yield Curve Across Countries and Time

• Date: 01 June 2015
• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/infi.12064

The Predictive Power of the

Yield Curve Across Countries

and Time

Menzie Chinn

y

and Kavan Kucko

z

y

University of Wisconsin-Madison, and NBER, and

z

Boston University.

Abstract

In recent years, there has been renewed interest in the yield curve (or

alternatively, the term premium) as a predictor of future economic

activity. In this article, we re-examine the evidence for this predictor

for both the United States and other advanced economies. We examine

the sensitivity of the results to the selection of countries, and to time

periods. We find that the predictive power of the yield curve has

deteriorated in the last half of the sample period, although there is

evidence of a reversal in the lead-up to the Great Recession. There is

reason to believe that European country models perform better than

those with non-European countries when using more recent data.

In addition, th e yield curve proves to have predic tive power even afte r

accounting for other leading indicators of economic activity.

We thank Shaghil Ahmed, Steve Kamin, Jagjit C hadha, seminar par ticipants at the US Treasury,

conference participants at the 10th EABCN conference (Frankfur t, 30–31 March 2009), the 201 3

Barcelona GSE Summer Forum and the C onference on Recent Developments in the Econometr ics of

Macroeconomics and Finance at the Norges Ba nk, and an anonymous referee for useful comm ents.

Paul Eitelman provided assistan ce with the data analysis. Luci o Sarno and Catherine B onser-Neal

graciously provided data. T he views expressed in this art icle are solely the respons ibility of the

authors and should not be interpreted as reflec ting the views of the NB ER.

International Finance 18:2, 2015: pp. 129–156

DOI: 10.1111/infi.12064

© 2015 John Wiley & Sons Ltd

I. Introduction

In 2006, several observers noted the inversion of the yield cu rve in the United

States. That event sparked a resurgence in the debate over the usefuln ess of the

yield curve as an indicator of future economic activit y, with an inversion indicating

a slowdown (and in some formulations, a recession). Use of the inverted yield

curve as a recession indicator, while common in the United States, is not

widespread in other countries. Moreover, prior to the 2007 recession, there was

general agreement that –in light of the increased credibilit y ascribed to monetar y

policy –the yield cur ve no longer ser ved as a useful early warning signal for

growth slowdowns. Figure 1 displays the yield spread, the difference between long-

and short-term government interest rates, through time for the United States and

other select advanced economies. The yiel d spread dips and turns negative prior to

each recession period, including the recession beginnin g in 2007. For European

countries, the relationship is not as consi stent but there does appear to be some

level of coincidence.

The motivation for study ing the yield sprea d is manifold. First, p olicymakers

often need to adjust p lans to anticip ate future economic cond itions. Alth ough

policymakers rely on a range of dat a and methods in forecast ing future conditi ons,

movements in the yield curve have in the pas t provided useful insights, a nd could

still represent a useful tool. Se cond, variations in cor relation between ass et prices

and economic activ ity might inform de bates regarding the working s of the macro-

economy. Precisely which countries exhibit a robust rel ationship between the y ield

curve and growth might be sug gestive of certain chann els being importa nt, to the

exclusion of others. A similar s ort of reasoning applies to ex amining the good ness of

fit over different time pe riods.

While there is already a voluminous literatu re on the subject of yield cur ves and

US economic activi ty, we nonetheless believe now is an oppor tune time to re-

examine the evi dence. This convict ion is rooted in several developm ents.

The first is the advent of the euro in 1999. With the creat ion of a more inte-

grated European bond market, and increas ed economic linkages on th e real side,

the historical link s (or non-links, as the c ase may be) between interest r ates and

output might have changed. Yet, until the Great Recession, there had n ot been a

sustained and significant downturn in the po st-EMU Europea n economy, and,

hence, little opport unity to test the predic tive power of the yield cur ve in this

context.

The second is the ‘conundrum’, that is, the failu re of long-term interest rates to

rise along with the short-term policy rate in the mid-2000s. Some people ascribed

the ‘conundrum’to the disappearance of risk, variously associated wi th the cross-

country decline in inflati on and output volatilit y –what is sometimes called the

‘Great Moderation’–or with greater ri sk-management on the part of financial

institutions. Others have focused on pension funds’dem and for long-term asset s, or

130 Menzie Chinn and Kavan Kucko

© 2015 John Wiley & Sons Ltd