Detecting crisis vulnerability using yield spread interconnectedness

Abstract

AbstractThis paper explores the interconnections among foreign term spreads across different economies and their systemic implications on crisis vulnerability. The term spread, understood as the difference between long‐term and short‐term interest rates on Treasury securities, has a well‐known predictive ability to forecast economic recessions in the short‐run. An initial explanatory analysis evidences an increasing correlation between term spreads in the recent years and, in particular, the constitution of country clusters whose term structures share common latent factors. Moreover, these correlations seem to have augmented after the last international financial crisis. Further, the results from a probit model considering domestic term spreads, supply shocks on oil and energy prices, and an international term spread network structure reveal a statistically significant effect of term spread interconnectedness on future economic output. Following, this paper empirically shows how an increasing number of Granger‐causality in‐degree connections may be associated with a higher crisis vulnerability in the short‐run. Additionally, a panel data regression corroborates the latter result to be robust under a wide range of conditions. Thus, an economy whose term spread is significantly caused in the Granger sense by external yield rates may be more prone to experience future recessions.