Recession Prediction Using Yield Curve and Stock Market Liquidity Deviation Measures

This paper extends the benchmark Estrella and Hardouvelis (1991) term spread approach to recession forecasting by including the stock market macro liquidity deviation factor. We use a probit framework to predict US business cycles, as defined by the NBER between 1959Q1 and 2011Q4. We find that combining the yield curve parameter with the stock market liquidity deviation significantly improves our ability to predict the onset of a US recession, based both on in-sample and out-of-sample tests. In addition, changes in stock market depth further increase the accuracy of the model. Our findings suggest that economic forecasters and those charged with conducting economic stabilization policy more generally would benefit from monitoring not only the yield curve but also stock market depth and liquidity, and their deviation from one another