Reliability of the term spread as a predictor of recession probabilities may be affected by zero short-term interest rates, according to a Federal Reserve Bank of Cleveland advisor.
Term spread, the difference between long- and short-maturity Treasury yields, the Fed said, "has produced intriguingly accurate predictions of economic activity and recessions in the US and abroad."
But, with high-quality bond yields remaining near zero in recent years, term spread may not provide accurate projections of economic activity, according to O. Emre Ergungor, a senior economic advisor at the Cleveland Federal.
Institutional investors search for riskier investment as opposed to accepting a negative yield from a fixed-income bond, Ergungor says. "Therefore, the yield curve may not invert when it should or as much as it should despite the anticipated path of the recovery."
Adding credit spread (the difference between the yields of high- and low-quality bonds) to the formula, improves the "accuracy when predicting recessions 12 months ahead than a model that includes only the term spread." But credit spread also faces the zero-lower-bound problem.
The inflation-adjusted quarterly change in pre-tax corporate profits could also be combined with term spread. "Firms seem to adjust their production and investment after seeing a drop in their profits," Ergungor said.
