There has been considerable attention paid to the possibility that financial spreads might be useful for predicting cyclical movements in aggregate output. Spreads are thought to contain timely information for a number of reasons, including the sensitivity of spreads to changes in expectations of cyclical changes. Spreads may widen due to anticipated increases in default risk as an economy slows down, or as monetary policy is tightened. It is natural to ask what additional explanatory power financial spreads have for predicting changes in aggregate output when other information, including lagged changes in output and other macro economic variables, are taken into account?
In this paper, empirical models are used to investigate this question with reference to the United Kingdom and Germany. The same methodology is followed for each case. Four financial spreads are used. The first is the long-term credit quality spread, which is the difference between yields on corporate and government bonds of the same maturity. The second is the yield curve, the differential between long and short rates. The final two are both reverse yield gaps. One is defined as the spread between the long-term bond yield and the dividend yield, the other is between bond yields and the earnings yield. The empirical tests consist of first estimating a robust and well-fitting Vector-Auto Regression (VAR) model of the economy, including output, the output deflator, and other macrovariables (six are used in total). Each model is then augmented by the four spreads, and a ten-equation VAR is estimated for each country. A variety of tests of the information contained in the spreads shows that they clearly contribute significantly to explaining changes in activity. In addition, ex-post tests of the predictive properties of the models indicate that the models that include spreads are more accurate in anticipating the recent cyclical downturn that occurred in the United Kingdom and Germany than the VAR models that do not include spreads.
The paper concludes that, on the basis of these tests, financial spreads may have an important empirical role in accounting for cyclical movements in aggregate activity.