An Explanation of Spread's Ability to Predict Economic Activity: A Regime Switching Model

Abstract

This study contributes to the relevant literature by providing an explanation on the reason and the economic conditions under which the spread proves to be such a powerful predictor of economic activity. For over two decades numerous studies have provided evidence on the predictive ability of the yield spread for real economic growth. While all this large literature has focused on how well the spread helps towards predicting real activity, none of these studies has given an answer on why the spread predicts. This study deals with this issue by attempting to find an answer on the reason and the economic conditions under which the spread proves to be such a powerful predictor of economic activity. We examine whether the explanation of spread’s predictive ability lies behind interest rate volatility, supposing that the economy oscillates between high and low volatility regimes. For this reason we nest GARCH models into Markov regime switching models.

When we assume that the economy simply oscillates between different regimes, interest rate volatility does not explain the spread’s predictive ability. However, we obtain a very interesting result when we augment the conditional variance with a level effects term. This ensures that in an environment with high levels of interest rates - in which the rational agents expect the economy to slow down - there is a greater possibility for the economy to switch to a high volatility regime. Under these economic conditions, interest rate volatility appears to be the reason of spread’s predictive power from one up to three years.

Keywords: Yield Spread, Business Cycles, GARCH Models, Regime Switching Models

JEL Classification: C3, E3, E4