Learning from History: Examining Yield Spreads as a Predictor of Real Economic Activity

Economists often use complicated models in an attempt to predict economic activity; however, in recent years, attention has shifted toward more simplistic forecasting methods that have the potential to yield equally useful results. One such method involves examining the predictive power of interest rate yield spreads. The spread in interest rates offered for different debt securities with identical maturities reflects the required compensation investors demand for bearing extra risk. Within the market forces driving yield spreads lies tacit information of market expectations. The goal of this study is to examine yield spreads of various debt securities and compare changes in those spreads to changes in economic activity across the past 50 years. By using statistical methods to compare the relationships of various yield spreads to real economic activity, this paper will show the value of using interest rate yield spreads to forecast economic activity and determine which spreads are most valuable as predictors.