A Dynamic Factor Model of the Yield Curve as a Predictor of the Economy

Abstract

In this paper, we propose an econometric model of the joint dynamic relationship between the yield curve and the economy to predict business cycles. We examine the predictive value of the yield curve to forecast future economic growth as well as the beginning and end of economic recessions at the monthly frequency. The proposed nonlinear multivariate dynamic factor model takes into account not only the popular term spread but also information extracted from the level and curvature of the yield curve and from macroeconomic variables. The nonlinear model is used to investigate the interrelationship between the phases of the bond market and of the business cycle. The results indicate a strong interrelation between these two sectors. The proposed factor model of the yield curve exhibits substantial incremental predictive value compared to several alternative specifications. This result holds in-sample and out-of-sample, using revised or real time unrevised data.

Keywords: Forecasting, business cycles, dynamic factor models, Markov switching

JEL Classification: C32, E32, E44