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Since writing the article, the economy ha s experienced a recession. My research showed that the slope of the term structure correctly predicted the four cyclical turnings points over the last 25 years.
Now we have a fifth. How did the model perform in this out-of-sample test? Indeed, there is m uch discussion of an pending recession in What does the term structure tell us about the next business cycle turning point.
In my dissertation at the University of Chicago inI argued that the term structure of interest rates could be used to forecast economic growth. Since the writing of the paper, we have experienced a complete business cycle.
Now, we can perform a post-mortem on the out-of-sample performance. I will show that the term structure model provided accurate and timely forecasts of the most recent business cycle.
The model predicted a downturn five quarters before the recession officially began. The model forecast the duration of the recession to be three quarters which is now considered the official length.
Furthermore, I will argue that the term structure provided the correct signal in early when the interest rate curve flattened. Basic Intuition Consider the basic intuition behind the model. Interest rates are ex ante measures representing expected future payoffs. When market rates are set, it is plausible to assume that expectations of future economic growth influence this process.
Consider a simple example. Assume that investors want to insure their economic well being. Most would prefer a reasonably stable level of income rather than very high income in one stage of the business cycle and very low income in another stage.
This pre ference for stability drives the demand for insurance or hedging. Suppose the economy is presently in a growth stage and the general consensus is for a slowdown or recession during the next year. This desire to hedge will lead consumers to purchase a financial instrument that will deliver payoffs in the slowdown.
Such a n instrument is a one year discount bond. If many people are buying the one-year bond, the price of the security will increase and the yield to maturity will decrease.
To finance the purchase of the one year bonds, consumers may sell their shorter term assets. This selling pressure will drive down the price of the short term instrument, and as a result, raise its yield. So, if a recession is expected, we will see long rates decrease and short rates will increase.
As a result, the term structure or yield curve difference between long rates and short rates will become flat or inverted. The shape of the term structure o f interest rates today provides a forecast of future economic growth.Campbell Russell "Cam" Harvey (born June 23, ) is a Canadian economist, His Ph.D.
thesis explored the concept that the term structure of interest rates (difference between long-term interest rates and short-term rates) could predict the US business cycle.
Picture with dissertation chair, Eugene F. Fama, May Publications "The Real Term Structure and Consumption Growth," Journal of Financial Economics 22, (): Campbell R. Harvey's dissertation showed that an inverted yield curve accurately forecasts US recessions.
On the other hand, throughout the 19th and early 20th century, the US economy experienced trend growth with persistent deflation.
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Campbell Harvey, a professor of finance at Duke University’s Fuqua School of Business, discovered the relation between the yield curve and future economic growth in Harvey discusses the yield curve, and why it isn’t yet predicting a recession, in this Fuqua Q&A.
Overview In my University of Chicago dissertation in and my September/October Financial Analysts Journal article, I proposed a method to forecast economic growth from the term structure of interest rates.
Since writing the article, the economy ha s experienced a recession.