Allison K. Rodean

Massimo Guidolin

English

Research Papers in Economics

April 2008 MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
T
he recent disassociation between the term spread
and the real growth rate can be explained in part by
the finance fundamentals behind the concept of the
term spread. The term spread, commonly defined as the
difference between the yields on 10-year U.S. government
bonds and 3-month Treasury bills, can be interpreted as a
risk premium: the additional amount of compensation
required to commit wealth into long-term investments in
the face of unanticipated inflation shocks. The reasoning is
simple: Should inflation accelerate unexpectedly, nominal
interest rates are likely to promptly increase. While an
investor buying T-bills could access higher yields quickly,
an investor who has purchased bonds could not and will
suffer a loss since the new nominal interest rates are higher
than the bond’s rate. Because this loss may be substantial if
the bond is far from maturity, bond investors require a reward
in the form of a term spread.1
We can quantify inflation risk by using the volatility of
long-term bond yields. If there is substantial inflation risk,
investors will tend to revise often their expectations of future
inflation rates. This process affects long-term bond prices
and causes volatility in their yields.
If inflationary risks decline independently of business
cycle conditions, long-term bond yields become less volatile
and the quantity of risk declines; this causes the term spread
to decrease as well. The table shows this has been true over
the past 26 years. In the Volcker era, the average realized
(computed using daily yields), annualized volatility on 10-
year government bonds had been 3.7 percent with a 2.2
percent term spread. Under Greenspan, the average realized
volatility declines to 1.3 percent and the term spread
declines to 1.7 percent.
However, the past two years have been characterized by
a very low volatility in the bond market (0.7 percent) and
virtually no term spread (0.04 percent). And the past decade
has been characterized by less than half the risk formerly
in the bond market, and at the same time the term spread
has declined by approximately one-half. 
Low or negative term spreads are conventionally seen
as harbingers of recession. Between January 2005 and
December 2007, the term spread declined to an average of
0.35 percent per year. Surprisingly, over the same period,
real GDP maintained a brisk pace of almost 3 percent per
year. Is it surprising the U.S. term spread has stopped fore-
casting real economic growth? No, because the term spread is
a risk premium compensation that declines when risk disap-
pears. For support, we have computed correlations between
the term spread and the real GDP growth rate for two sub-
samples: 1981-94 and 1995-2007.2 We find a high and statis-
tically significant correlation in the first, high-volatility sub-
sample, 0.36; with sufficient risk, the term spread is positive
and varies to reflect anticipations of future business cycles.
Over the second, low-volatility subsample the term spread has
lost any association to real economic growth: The correlation
is essentially zero (–0.03) and is not statistically significant. If
the term spread mostly depends on inflationary risk and such
risks disappear over time, poor forecasting performance is
expected. It is ironic that the very success of Chairmen
Greenspan and Bernanke at fighting inflation and anchoring
inflationary expectations may have led to a new era in which
forecasters and policymakers struggle with the loss of the term
spread’s predictive power. The business cycle remains difficult
to forecast, although with stable inflation, the loss of a forecast-
ing instrument seems a small price to pay.
—Massimo Guidolin and Allison K. Rodean
1 The term spread also depends on other factors, e.g., the differential liquidity of
the short and long term segments of the bond market and, in principle, the uncer-
tainty of future real interest rates. Even though we recognize that these factors are
like to be priced in the term spread, we simply assume a direct relationship between
the term spread and the variance of excess long-term bond returns.
2 Consistently with the literature, we apply a lag of 3 quarters in the relationship,
i.e., real GDP growth today is predicted by the term spread 3 quarters ago. There
has been some recent debate on whether and why the term spread may actual
forecast business cycle conditions: See Anderson, R. “Yield Curve Inversions and
Cyclical Peaks.” Federal Reserve Bank of St. Louis Monetary Trends, May 2006.
No Volatility, No Forecasting Power for the Term Spread
research.stlouisfed.org
Average Average  Number  of 
Date range term spread votility months
Volcker era 2.187 3.695 71
(9/1981–7/1987)
Greenspan era 1.689 1.296 222
(8/1987–1/2006)
Bernanke era 0.036 0.747 23
(2/2006–7/2007)
9/1981–12/1994 2.129 2.420 160
1/1995–7/2007 1.220 1.153 156

No volatility, no forecasting power for the term spread

http://research.stlouisfed.org/publications/mt/20080401/cover.pdf

No volatility, no forecasting power for the term spread

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