Regime switches in the yield curve-credit spread relationship and the prediction of recessions

This chapter deals with the dynamic relationship between term and credit spreads within a framework that incorporates regime shifts. Through the estimation of an asymmetric Markov-Switching Vector Equilibrium Correction Model (MS-VECM), comprising the short- and the long-term risk-free rate and the Moody's Baa-rated bond rate, we arrive at three basic results. First, the short-run relationship between credit and term spreads is regime dependent, being negative and significant during low volatility periods only and in the presence of an inverted yield curve. Second, through an impulse response analysis, it is established that the response of credit spreads to a given change in the term spread depends on the rate, short- or long term, that has caused this change. Third, a probit analysis reveals that the credit spread is a useful predictor of future economic recessions, both at a six-month and a one-year ahead horizon, and that this result is valid even in the presence of the term spread variable.