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Board of Governors of the Federal Reserve System (U.S.)
Finance and Economics Discussion Series
The Near-Term Forward Yield Spread as a Leading Indicator : A Less Distorted Mirror
Eric Engstrom
Steven A. Sharpe
Abstract

The spread between the yield on a 10-year Treasury bond and the yield on a shorter maturity bond, such as a 2-year Treasury, is commonly used as an indicator for predicting U.S. recessions. We show that such “long-term spreads” are statistically dominated in recession prediction models by an economically more intuitive alternative, a ""near-term forward spread."" This latter spread can be interpreted as a measure of the market's expectations for the near-term trajectory of conventional monetary policy rates. The predictive power of our near-term forward spread indicates that, when market participants expected—and priced in—a monetary policy easing over the next 12-18 months, this indicated that a recession was quite likely in the offing. Yields on bonds beyond 18 months in maturity are shown to have no added value for forecasting either recessions or the growth rate of GDP.


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Eric Engstrom & Steven A. Sharpe, The Near-Term Forward Yield Spread as a Leading Indicator : A Less Distorted Mirror, Board of Governors of the Federal Reserve System (U.S.), Finance and Economics Discussion Series 2018-055, 07 Aug 2018.
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Keywords: Policy path ; Recession forecast ; Yield spread ; Monetary policy
DOI: 10.17016/FEDS.2018.055
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