The Yield Curve as a Tool For Predicting Recessions

Christoffer TorngÄrd Retz & Sarah Hegelund Nielsen

Student thesis: Master thesis


goal of this thesis is to examine if the yield curve can be used as a predictor for recessions. The indication of a recession will appear when the yield curve inverts and this happens when the short-term interest rates exceed the long-term interest rates. It investigates different interest rates and different lags in the search of the best predicting model with the use of probit regression and the NBER definition of a recession. The time around the financial crisis was among other things characterized by short-term interest that were near the zero lower bound. The use of traditional monetary policy by the Federal Reserve was constrained by the zero lower bound and the Federal Reserve had to take other actions in order to stimulate the economy. This was done by large scale assets purchases and through forward guidance. This thesis examines both the yield curve as a predictor for recessions but also how the yield curve is affected by the zero lower bound, QE-programs and forward guidance. The analysis of the yield curve as a predictor for former recessions suggested that the yield curve has been effective at predicting past recessions. The models were evaluated by the use of pseudo-R2 and the results were, that the efficiency of the spreads were different under given lags. The zero lower bound was examined in relation to the Taylor rule and the Wu-Xia shadow rate. This indicated that the Taylor rule was negative around the period after the financial crisis and the analysis of the Wu-Xia shadow rate showed that the Federal Reserve was successful in stimulating the economy in a likely approach as a reduction in the federal funds rate would have been. The analysis also showed that the Federal Reserve was successful at lowering the long-term interest rates with the QE-programs. Forward guidance was also examined in relation to its effect on the yield curve and results implied that forward guidance could have a significant effect on the yield curve as well. This study therefore suggests that while the yield curve has been effective at predicting recessions in the past it is uncertain whether new factors such as unconventional monetary policy by the central bank can disturb the yield curve and its predictive power as of today.

EducationsMSc in Finance and Accounting, (Graduate Programme) Final Thesis
Publication date2019
Number of pages109