Recently sharing and discussing on the economic growth and the debt market yield spread impact recalled me some blogwork I did in the past and its worth sharing,

The abstract was based on the evidence that yield spread can serve as a leading indicator of economic activity.It’s important to understand few basic concepts before moving forward:

YIELD SPREAD: The difference between yield of long-term debt and short-term debt instrument is known as yield spread. Higher the difference between instruments greater will be the yield spread.

For example, if the 05-year Treasury bond is at 3% and the 20-year Treasury bond is at 4%, the yield spread between the two debt instruments is 1% (4% – 3%).

TERM STRUCTURE: Term structure of interest rates is the relationship between maturity and yield of the bond.  The term structure is also known as yield curve, if we plot it in (X, Y) plan.

RELATIONSHIP BETWEEN PRICE AND YIELD

The relationship between price and yield is not a straight line but it’s a convex. Percentage price change is different if required yield is changed.

For a small change in yield, price change of bond is approximately the same, in other words percentage price change increased or decreased is the same if we change yield for the given basis. But for a large change in yield percentage price change is not the same but different, percentage price change increased is more than percentage price change decreased for given change in yield.

RELATIONSHIP BETWEEN YIELD SPREAD AND ECONOMIC GROWTH

Slope of Yield curve reflects the policy stance and actions taken by monetary authority in the current period. Temporary monetary contraction by the central bank in current period increase the nominal short-term interest rates and owing to price rigidity , real short-term interest rates while leaving  long-term interest rates intact. This results in a lowering of yield spread and a flattening yield curve. At the same time high real interest rates also means low-level of investment in the current period and hence lower output in the near future. Hence the association between lowering of yield spread and fall in future output growth.

Several papers have been published like Campbell Harvey and IMF working paper.  Harvey says that Term structure have ability to predict economic growth in the future. Harvey in 1991 found that in case of Germany, slope of yield curve has significant ability to predict future GNP growth. Fama in 1986 and later Stambaugh in 1988 mentioned that term structure appears to predict real economic activity although these were not supported by any detailed statistical analysis.

Estrella and Mishkin (1998) examined the ability of yield spread to predict recession in case of France, Germany, Italy, UK and USA. They found that ability to predict recession has been highest in case of USA and Germany followed by UK.

These several studies show that yield spread has ability to predict growth in the near future. In other words slope of yield curve reflects economic growth.

It would be interesting to do the study on Indian markets 🙂

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