Financial Analysts Journal 12 Jul 2019 Volume 75 Issue 4
The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted Mirror
The spread between the yields on a 10-year US T-note and a 2-year T-note is commonly used as a harbinger of US recessions. We show that such “long-term spreads” are statistically dominated in forecasting models by an economically intuitive alternative, a “near-term forward spread.” This spread can be interpreted as a measure of market expectations for near-term conventional monetary policy rates. Its predictive power suggests that when market participants have expected—and priced in—a monetary policy easing over the subsequent year and a half, a recession was likely to follow. The near-term spread also has predicted four-quarter GDP growth with greater accuracy than survey consensus forecasts, and it has substantial predictive power for stock returns. Once a near-term spread is included in forecasting equations, yields on longer-term bonds maturing beyond six to eight quarters have no added value for forecasting recessions, GDP growth, or stock returns.
About the Author(s)
Eric C. Engstrom is Deputy Associate Director, Division of Monetary Affairs, and Adviser, Division of Research and Statistics, at the Board of Governors of the Federal
Reserve System, Washington, D.C.
Steven A. Sharpe is Deputy Associate Director, Division of Research and Statistics, at the Board of Governors of the Federal Reserve
System, Washington, D.C.