The Term Structure of Interest Rates as Predictor of Stock Returns: Evidence for the IBEX 35 During a Bear Market

Abstract

We present a model to forecast the probability of bear markets in the Spanish IBEX 35 with a congruent and concise parameterization which selects the explanatory factors from a wide set of variables like the yield curve of Spain, US and Europe, as well as several macro variables, and numerous leading indicators.

To this end, we first use a data-guided algorithm to select an in-sample optimal Probit model that is employed as a benchmark. We then form alternative Probit models obtained from combinations of levels, slopes and/or curvatures in the yield curve of Spain, US and Europe, as well as several macro variables and compare their estimated probability of bear markets in the out-of-sample period with that from the benchmark model. Our results suggest that the slopes of US and Europe yield curves have some information content (not implicitly present in the slope of the Spanish yield curve) that helps to better forecast the probability of bear markets in the IBEX 35.

Keywords: Term structure of interest rates, Stock returns, Trading strategies

JEL Classification: E43, G15, C20