How Can Yield Curve Analysis Help Predict Future Recessions

Since the 1980s there have been arguments over the effectiveness of yield curve analysis to predict future economic development. It has been slightly neglected as a forecasting tool, even with its many recorded accuracies in predictions on several past recessions.

There are a number of reasons why the steepness of the yield curve can be considered a good indicator of a probable future recession. Existing monetary guidelines have a momentous effect on the yield curve spread as well as real movement on the next numerous quarters. An increase in the short rate tends to compress the yield curve as well as lessen real development in the near term. This relationship is just one of the reasons why it is an effective forecasting tool. Future economic activity can be predicted by making use of the anticipations of future inflation and real interest rates that are included in the yield curve spread.

In an article in 1900, Mishkin explained that a forward interest rate can be divided into expected inflation and real interest rate components, in which both are valuable in prediction. There is a possibility that the expected real rate can be related to expectations of future monetary guidelines and for this reason it can also be associated with future real growth. An inflation component can also provide an idea of future growth since inflation is most likely to be positively correlated to activity.

Aside from performing yield curve analysis, there are also other variables commonly utilized to predict the economy’s direction. Stock prices are among the financial variables that are gaining a lot of attention. The implication on the finance theory states that prices of stocks are identified by expectations about future dividend flows, which can then be associated to the future economic condition.

The Conference Board’s index of top economic indicators is among the macroeconomic variables that gained a good reputation in being able to forecast real economic activity. However, its reputation has not been often subjected to careful assessments. Many perceive its success to have a possibility of being exaggerated since it has undergone persistent modifications in an attempt to enhance its performance. There is a better alternative though and it is the 1989 Stock and Watson index of leading economic indicators.

Performing yield curve analysis has been successful in predicting many past recessions. Although it is often perceived as complex, there are tools that make analyses quicker and easier by allowing users to view the shape of the par, zero and forward yield curves in either a non-smoothed or smoothed fashion and then compare the effects of the smoothing with the assessment of a portfolio. The digital animations of these tools provide a clear presentation of the effects of the alterations in a number of yield curves as well as assist in the identification of the suitable forward curve position to take.

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