Although there may be more finely tuned models, inverted yield curves have an excellent track record as a predictor of recessions. Research show yield curves are mean reverting, notable for the US, which is coming off record yield curve steepness.
Last week interest rate markets in both Indian and Brazilian markets inverted. Australia is not far behind. Strategists have taken note. Richard Bernstein said “I think what people are completely missing is that the risk is not here in the United States,” he told the Reuters 2011 Investment Outlook Summit. “The risk is in emerging markets. There are just monstrous risks in emerging markets right now in my opinion.” On which countries, “If you look at inverted yield curves around the world, the most inverted yield curves are Greece, Ireland and Portugal, and then comes India and Brazil. There is your warning sign that no one is talking about,” he said.
Deutsche Bank’s John Paul Smith added “There’s a significant chance we get a fairly major sell-off,” he said of emerging markets. “China is so untransparent but massively important for asset classes and global markets.”
Clearly, they are late to the game. And there is no mention of the massive credit bubbles in Turkey and China, and to a lesser extent in Brazil and India. That’s the real source of risk.
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.
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
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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