What Does the Yield-Curve Slope Really Tell Us?

Abstract

The slope of the yield curve is a widely used predictor of the future business cycle. Yet the literature is unclear about why this occurs and which specific slope measures work best. In this article, the author focuses on the risk-taking channel of monetary transmission and argues that it is the overall pattern of bond term premia that matters, not just a single maturity combination. The changing curvature of the term structure over time, induced by fluctuations in these term premia, questions the robustness of the predictions from a single yield-curve slope. Since its principal components are also known to be unstable, investors need to be careful when extracting information from the yield curve. The author concludes that more parameters are needed to capture the information behind the pattern of term premia. He shows that measures of the lateral position of the curvature (D-star) predict recessions better than other more popular predictors.

TOPICS: Fixed income and structured finance, analysis of individual factors/risk premia, statistical methods