Do Financial Markets Predict Macroeconomic Performance? Evidence from Risk-Based Measures

Abstract

Financial markets are expected to predict macroeconomic conditions as their movements depends upon expectations of future performance. However, existing evidence is mixed. We argue that this is because the stock return and term structure series typically used in studies fail to capture investor risk preferences. To better capture risk, we use the variance risk premium (VRP) and default yield (DFY) and demonstrate that there is greater evidence of predictive power. In addition to the VRP and DFY, we include further variables that may also capture financial market risk. Moreover, given similar dynamics between the different risk measures and the potential for multicollinearity in estimation, we consider combinations of these variables. With results obtained through predictive regressions, out-of-sample forecasting and a probit regression designed to capture periods of expansion and contraction, we show that the combination variables are able to predict future movements in macroeconomic conditions as well as results using the individual variables. Of note, results show that combinations that include the VRP and DFY are preferred across all macro-series.

Keywords: Variance Risk Premium, Default Yield, Prediction, Economic Growth

JEL Classification: C22, G12