Summary of Research on the Usefulness of using the Yield Curve in Macro Forecasting

February 10, 2011

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Via Zerohedge, BNY Convergence, makes the argument that a manipulated yield curve, currently at record steepness, should be a contrarian indicator – link

  • Most investors consider this to be one of the most efficiently priced markets in the world. There’s plenty of supply, first of all, with $9.5 trillion in public hands. And then there’s a healthy leverage component – even a retail Fidelity margin account will allow you to buy more than 4x your cash balance. An accommodating prime broker will give you far more leverage without much of a fuss. Even before you layer on a robust futures market, the monthly trading in U.S. government bonds totals some $500 billion every month.
  • The short end of the Treasury curve, less than 2 years or so maturity, is largely controlled by interest rate policy driven by the Federal Reserve. They set short-term rates with their decisions on the Federal Funds rate, the overnight interest rate used by banks to lend money to other financial institutions.
  • The yields at the long end of the curve, essentially 5 – 30 years, are determined primarily by expectations for future inflation. U.S. Treasuries have long been considered “risk free” so they aren’t supposed to discount any risk of default. More on that in a few minutes, though.

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That being said, historically, the evidence has supported using the yield curve in a variety of manners.

Yield Curve Predicts Recessions

Previous research has demonstrated that, relative to carefully tailored forecasting variables such as the index of leading indicators, the yield curve is an excellent predictor of recessions. In this article, Michael Dueker shows that the predictive power of the yield curve does not diminish when examined in the context of econometric models with more sophisticated baseline forecasts.

The Yield Curve as  Predictor of Emerging Economies

It finds that the yield curve in emerging economies contains information for future inflation and growth, with differences across countries being seemingly linked to market liquidity. The US and euro area yield curves are also found to contain information for future inflation and growth in emerging economies

Data set : Yield Curve 1961-present

Unique Model : A Diagnostic for Yield Curve Models

 

Yield Curve and Volatility : Lessons from Eurodollar Futures and Options

We evaluate the statistical and economic differences between affine term-structure models.We estimate the models using the Eurodollar futures and options data as a basis and find a stochastic volatility model performs better than term structure models based on Gaussian volatility.

We find, based on the statistical tests and pricing errors, that there is little difference between the models when the models are estimated using only the yield curve information. Using options data enables us to separate the models very clearly. The stochastic volatility model is the most successful according to our diagnostics.

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