Aurora Borealis
12 July 2019 Financial Analysts Journal Volume 75, Issue 4

The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted Mirror

  1. Eric C. Engstrom
  2. Steven A. Sharpe
The spread between the yields on a 10-year US T-note and a 2-year T-note is commonly used as a harbinger of US recessions. We show that such “long-term spreads” are statistically dominated in forecasting models by an economically intuitive alternative, a “near-term forward spread.” This spread can be interpreted as a measure of market expectations for near-term conventional monetary policy rates. Its predictive power suggests that when market participants have expected—and priced in—a monetary policy easing over the subsequent year and a half, a recession was likely to follow. The near-term spread also has predicted four-quarter GDP growth with greater accuracy than survey consensus forecasts, and it has substantial predictive power for stock returns. Once a near-term spread is included in forecasting equations, yields on longer-term bonds maturing beyond six to eight quarters have no added value for forecasting recessions, GDP growth, or stock returns.
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