The Yield Curve as a Predictor of Growth and Recession in Australia

This paper estimates the slope of the yield curve using quarterly data on real GDP and the nominal spread proxied by the difference in returns from the 10 year bond rate and the 90 day bill rate. The time-series analysis after proper unit root tests using stationary variables revealed that the yield curve gives the best forecasts on real activity over a forecast horizon of one year (4 quarters ahead). Non-nested tests of rival models of alternative financial indicators demonstrated that the yield curve outperforms other financial indicators as a robust predictor of future real activity. The probit model forecasts of recessions indicated that the inverted slope of the yield curve for 4-quarter horizon gave the best recession prediction for Australia. The probit model predictions also gave probability estimates for the occurrence of recessions for different nominal spreads or slopes of the yield curve. The probit model predictions of recessions improved dramatically when a dynamic lag structure was incorporated. Empirical evidence demonstrates that the yield curve outperforms other financial indicators as a predictor of recessions in Australia. It is a simple and operational tool that can be validated using up-to-date data.