Does the yield spread retain its forecasting ability during the 2007 recession? A comparative analysis

Abstract

We review spread’s predictive ability by implementing a number of linear and probit models. We conduct a comparative analysis of the forecasting performance of various specifications by focusing on the last three major US economic slowdowns: 1990, 2001 and 2007. The results indicate that although linear models are useful in predicting the 1990 and 2001 decline in economic activity, none of these give signal of the major 2007 decline in output. Moreover, we find evidence that there is more information in the shape of the yield curve about the future economic activity than that provided by the spread alone. We also document that probit models are doing well in signalling the onset of 2007 subprime crisis although they fail to capture its duration.

Keywords:

• yield spread
• business cycles
• probit models

JEL Classification:

• C35
• E43
• E52

Notes

¹ Notice that when we checked for the forecasting ability of our models for k > 8, we get very poor out-of-sample fitting with R² < 0.1 for every quarter and every model.