Have You Analyzed the Yield Curve as an Indicator?
Posted in Economic Indicators
September 11, 2009
A reader asked: “Have you analyzed this indicator (charts here)? Specifically, the 1996 article ‘The Yield Curve as a Predictor of U.S. Recessions’ by Arturo Estrella and Frederic Mishkin explains how the yield curve significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead.”
CXOadvisory.com focuses on financial markets and thus on research that connects economic indicators directly to asset classes like stocks. The relationship between recessions and stock market returns is messy. See, for example, “The Probability of Recession and Future Stock Returns”.
Researchers have frequently investigated the yield curve (term spread) as a stock market return indicator, sometimes using it a benchmark for testing the ability of other macroeconomic indicators to predict stock returns. See:
“Employment Growth and Stock Returns”
“Following the ‘Hot’ Economic Indicators”
“Why the Story on Predictability Keeps Changing”
“An International Test of Common Stock Return Indicators”
“Growth Versus Value and the Yield Curve”
While academic studies often find statistical significance for the power of economic indicators to predict stock market returns, that significance generally translates to explanatory power of only a small fraction of stock return variation over horizons of a few quarters to a few years. Some of these studies assume normality of stock market return distributions; to the extent the distributions are “wild” rather than normal, the statistical methods are defective.
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