The yield spread, measured as the difference between long- and short-term interest rates, is widely regarded as one of the strongest predictors of economic recessions. In this paper, we propose an enhanced recession prediction model that incorporates trends in the value of the yield spread. We expect our model to generate stronger recession signals because a steadily declining value of the yield spread typically indicates growing pessimism associated with the reduced future business activity. We capture trends in the yield spread by considering both the level of the yield spread at a lag of 12 months as well as its value at each of the previous two quarters leading up to the forecast origin, and we evaluate its predictive abilities using both logit and artificial neural network models. Our results indicate that models incorporating information from the time series of the yield spread correctly predict future recession periods much better than models only considering the spread value as of the forecast origin. Furthermore, the results are strongest for our artificial neural network model and logistic regression model that includes interaction terms, which we confirm using both a blocked cross-validation technique as well as an expanding estimation window approach.
Journal of Applied Statistics
Kozlowski, Steven E. and Sim, Thaddeus, "Predicting recessions using trends in the yield spread" (2018). Business Faculty Publications. 244.
Kozlowski, Steven E., and Thaddeus Sim. “Predicting Recessions Using Trends in the Yield Spread.” Journal of Applied Statistics 46, no. 7 (June 2019): 1323–35. doi:10.1080/02664763.2018.1537364.