Research Review | 12 July 2019 | Yield Curve Analysis

Yield Curve and Financial Uncertainty: Evidence Based on Us Data
Efrem Castelnuovo (University of Melbourne)
June 2019
How do short and long term interest rates respond to a jump in financial uncertainty? We address this question by conducting a local projections analysis with US monthly data, period: 1962-2018. The state-of-the-art financial uncertainty measure proposed by Ludvigson, Ma, and Ng (2019) is found to predict movements in interest rates at different maturities. In particular, an increase in financial uncertainty is found to trigger a negative and significant response of both short and long term interest rates. The response of the short end of the yield curve (i.e., of short term interest rates) is found to be stronger than that of the long end (i.e., of long term ones). In other words, a financial uncertainty shock causes a temporary steepening of the yield curve. This result is consistent, among other interpretations, with medium-term expectations of a recovery in real activity after a financial uncertainty shock.

Why Does the Yield-Curve Slope Predict Recessions?
Luca Benzoni (Federal Reserve Bank of Chicago), et al.
December 2018
Why is an inverted yield-curve slope such a powerful predictor of future recessions? We show that a decomposition of the yield curve slope into its expectations and risk premia components helps disentangle the channels that connect fluctuations in Treasury rates and the future state of the economy. In particular, a change in the yield curve slope due to a monetary policy easing, measured by the current real-interest rate level and its expected path, is associated with an increase in the probability of a future recession within the next year. In contrast, a decrease in risk premia is associated with either a higher or lower recession probability, depending on the source of the decline. In recent years, a decrease in the inflation risk premium slope has been accompanied by a heightened risk of recession, while a lower real-rate risk premium slope is a signal of diminished recession probabilities. This means that not all declines in the yield curve slope are bad news for the economy, and not all instances of steepening are good news either.

Deconstructing the Yield Curve
Richard K. Crump (NY Fed) and Nikolay Gospodinov (Atlanta Fed)
April 1, 2019
We investigate the factor structure of the term structure of interest rates and argue that characterizing the minimal dimension of the data-generating process is more challenging than currently appreciated. To circumvent these difficulties, we introduce a novel nonparametric bootstrap that is robust to general forms of time and cross-sectional dependence and conditional heteroskedasticity of unknown form. We show that our bootstrap procedure is asymptotically valid and exhibits excellent finite-sample properties in simulations. We demonstrate the applicability of our results in two empirical exercises: First, we show that measures of equity market tail risk and the state of the macroeconomy predict bond returns beyond the level or slope of the yield curve; second, we provide a bootstrap-based bias correction and confidence intervals for the probability of recession based on the shape of the yield curve. Our results apply more generally to all assets with a finite maturity structure.

The Inverted Curve and Recession: A Hoax, When It Ends?
Yosef Bonaparte (University of Colorado at Denver)
June 17, 2019
The paper shows that the chance inverted curve predicts recession is less than 3.9%, and even not statistically significant. But then we ask why investors still see linkage between inverted curve and recession? The behavior psychology research demonstrates that, for the majority, bad events (such as the 2007 event) register stronger and longer than good events, and vivid in investors’ memory. Finally, we show that the strongest and best predictor for recession is the current GDP growth.

Does the Yield Curve Really Forecast Recession?
David Andolfatto (St. Louis Fed) and Andrew Spewak
November 30, 2018
Does the recent flattening of the yield curve portend recession? Not necessarily. The flattening of the real yield curve may simply reflect the fact that real consumption growth is not expected to accelerate or decelerate from the present growth rate of about 1 percent year over year. On the other hand, a 1 percent growth rate is substantially lower than the U.S. historical average of 2 percent. Because of this, the risk that a negative shock (of comparable magnitude to past shocks) sends the economy into technical recession is increased. While the exact date at which the shock arrives is itself unpredictable, the likelihood of recession is higher relative to a high-real-interest-rate, high-growth economy.

Empirical Analysis and Forecasting of Multiple Yield Curves
Christoph Gerhart and Eva Lütkebohmert (University of Freiburg)
January 8, 2019
In this paper we develop new dynamic factor models to forecast multiple yield curves. Our methodology is based on a thorough empirical study of daily tenor-dependent term structures over the time period 2005-2017 which reveals important cross-tenor dependencies of yields. The suggested forecasting approach accounts for these dependencies and thus targets the new features of post-crisis interest rate markets. Our method generates extremely precise predictions of future yield curves for various forecasting horizons. In particular, it clearly outperforms existing single-curve forecasting methods which naturally omit any connections between rates of different tenor structures.

Downturns and Changes in the Yield Slope
Mirko Abbritti (University of Navarra), et al.
September 8, 2018
We show that the slope of the sovereign yield curve not only predicts future economic activity through its level but also through its changes. Our results with US data show that the inclusion of the first difference of the slope in the traditional yield slope regressions significantly increases the explanatory power of the yield curve. Decomposing the yield slope changes into those of the risk-neutral spread and of the term premium also brings insights into future economic activity forecast. We find that, while positive changes to the risk-neutral spread predict lower economic activity in the short-run (1-3 months), positive changes to the term premium predict lower economic activity in the medium run (3-12 months). These results are obtained at both monthly (industrial production, unemployment) and quarterly (GDP growth, unemployment) frequencies and also in probit-type recession regressions.

(Don’t Fear) The Yield Curve
Eric Engstrom and Steven Sharpe (Federal Reserve)
June 28, 2018
In this note, we show that, for predicting recessions, such measures of a “long-term spread”–the spread in yields between a far-off maturity such as 10 years and a shorter maturity such as 1 or 2 years–are statistically dominated by a more economically intuitive alternative, a “near-term forward spread.” This spread can be interpreted as a measure of the market’s expectations for the direction of conventional near-term monetary policy. When negative, it indicates the market expects monetary policy to ease, reflecting market expectations that policy will respond to the likelihood or onset of a recession. By that token, the current level of the near-term spread does not indicate an elevated likelihood of recession in the year ahead, and neither its recent trend nor survey-based forecasts of short-term rates point to a major change over the next several quarters.

Dissecting the Yield Curve: The International Evidence
Andrea Berardi (Ca Foscari University of Venice) and A. Plazzi (Swiss Finance Inst.)
June 18, 2019
Using a stochastic volatility affine term structure model, we explicitly consider the interrelation between yield curves and macro and volatility factors. We provide estimates of short rate expectations, term premium and convexity of nominal yields and for their real and inflation components for four different currency areas: US, Euro Area, UK, and Japan. We find that in all areas there are non-negligible convexity effects in correspondence with high volatility periods, and that term premium and convexity explain a significant proportion of the dynamics at the long end of the yield curve. Using panel regressions, we show that, overall, short rate expectations are procyclical while term premia exhibit a countercyclical behaviour and tend to increase with yield volatility. We also detect strong cross-country co-movements both in short rate expectations and term premia, with the degree of connectedness exhibiting significant time variation.