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

FEDS Working Paper No. 2018-055

20 Pages Posted: 20 Aug 2018 Last revised: 3 Apr 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: August 7, 2018

Abstract

The spread between the yield on a 10-year Treasury note and the yield on a shorter maturity security, such as a 2-year Treasury note, is commonly used as an indicator for predicting U.S. recessions. We show that such “long-term spreads” are statistically dominated in models that predict recessions or GDP growth by an economically more intuitive alternative, a "near-term forward spread." The latter can be interpreted as a measure of the market's expectations for the near-term trajectory of conventional monetary policy rates. Its predictive power suggests that, when market participants expected—and priced in—a monetary policy easing over the subsequent year and a half, a recession was quite likely in the offing. We also find that the near-term spread predicts four-quarter GDP growth with greater accuracy than survey consensus forecasts and that it has substantial predictive power for stock returns. Yields on bonds maturing beyond 6-8 quarters are shown to have no added value for forecasting either recessions, GDP growth, or stock returns.

Keywords: Equity return predictability, Monetary policy, Policy path, Portfolio strategy, Recession forecast, Yield spread

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 (August 7, 2018). 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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