The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted Mirror

11 Pages Posted: 20 Aug 2018 Last revised: 21 Feb 2019

See all articles by Eric Engstrom

Eric Engstrom

Board of Governors of the Federal Reserve System

Steven A. Sharpe

Federal Reserve Board - Research & Statistics

Date Written: 2018-08-07

Abstract

The spread between the yield on a 10-year Treasury bond and the yield on a shorter maturity bond, such as a 2-year Treasury, is commonly used as an indicator for predicting U.S. recessions. We show that such “long-term spreads� are statistically dominated in recession prediction models by an economically more intuitive alternative, a ""near-term forward spread."" This latter spread can be interpreted as a measure of the market's expectations for the near-term trajectory of conventional monetary policy rates. The predictive power of our near-term forward spread indicates that, when market participants expected—and priced in—a monetary policy easing over the next 12-18 months, this indicated that a recession was quite likely in the offing. Yields on bonds beyond 18 months in maturity are shown to have no added value for forecasting either recessions or the growth rate of GDP.

Keywords: Policy path, Recession forecast, Yield spread, Monetary policy

JEL Classification: E52, G12

Suggested Citation

Engstrom, Eric and Sharpe, Steven A., The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted Mirror (2018-08-07). FEDS Working Paper No. 2018-055. Available at SSRN: https://ssrn.com/abstract=3234193 or http://dx.doi.org/10.17016/FEDS.2018.055

Eric Engstrom (Contact Author)

Board of Governors of the Federal Reserve System

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Steven A. Sharpe

Federal Reserve Board - Research & Statistics ( email )

20th & C. St., N.W.
Washington, DC 20551
United States
202-452-2875 (Phone)
202-452-3819 (Fax)

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