Do the capital markets contain information relevant for forecasting real output growth? For a long time, academics and the public have believed that the stock market in particular is a good forecasting mechanism. Fischer and Merton (1984), for example, claim that the stock price is the single best predictor of the business cycle. This paper makes the case that the bond market may actually be a better predictor of economic growth than the stock market.
This paper presents a simple model that yields a closed-form formula for the term structure of interest rates. It explicitly demonstrates the link between equilibrium interest rates and the real output process. Then, the paper documents how a term structure variable or, more specifically, the yield spread between long-term and short-term government bonds can be used to forecast GDP growth in the seven major industrial countries.
To evaluate the forecasting performance of the yield curve, the yield spread model is compared with the alternative stock price-based model and a univariate time-series model for GDP growth. It appears that the yield spread outperforms both models for the majority of the countries studied and also retains marginal forecasting power when other relevant information variables are included in the regressions.
These results suggest that it may be useful to add some measure of the term structure to the list of leading indicators, a status that the stock market price index has long enjoyed.