The Yield Curve as a Forecasting Tool of Recessions: The Case of the Euro Area

Several studies have established the predictive power of the yield curve, i.e.: the difference between long and short term bond rates, in terms of real economic activity. In this paper we use data for a variety of countries with divert financial and monetary backgrounds: the ones that participate in the EMU and the E.U. (Germany, France, Italy), the ones that are only members of the E.U. (Denmark and the U.K.) and the highly distinct case of Russia. The data used range from 1990:Q1 to 2009:Q2. For each country, the seasonally adjusted real GDP is employed to extract the long run trend and the cyclical component of real economic activity, while the corresponding interbank interest rates of long and short term maturities are used for the calculation of the country specific yield spreads. We also augment the models tested with non monetary policy variables: the countries’ unemployment rates and stock indices. The methodology employed in the effort to forecast real output, is a probit model of the inverse cumulative distribution function of the standard distribution, using several formal forecasting and goodness of fit evaluation tests. The coding of the binary dependent variable of real economic activity is such that it reflects an above or below-trend real output.  The results show that the yield curve augmented with the non-monetary variables has significant forecasting power in terms of real economic activity but the results differ qualitatively between the individual economies examined raising non-trivial policy implications.