The Application of Sovereign Bond Spreads: The Case of United Kingdom, Iceland, Norway, Switzerland and Russia

Abstract

The yield curve – specifically the spread between long term and short term interest rates is a valuable forecasting tool. It is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead. The steepness of the yield curve should be an excellent indicator of a possible future economic activity. A rise in the short rate tends to flatten the yield curve as well as to slow real growth the near term. This paper aims to analyze the dependence between slope of the yield curve and an economic activity ofUnited Kingdom, Iceland, Norway, Switzerland and Russia between the years 2000 and 2013. This time period was divided on two samples in order to prove the change of predictive power of the model. The slope of the yield curve can be measured as the yield spread between sovereign 10-year bonds and sovereign 3-month bonds. The natural and probably the most popular measure of economic growth is by GDP growth, taken quarterly. The results showed that the prediction ability of the GDP growth or decrease was proven after year 2008 (financial crisis) in Iceland, Russia and United Kingdom. Certainly the simple yield curve growth forecast should not serve as a replacement for the complex predictive models, it does, however, provide enough information to serve as a useful check on the more sophisticated forecasts. These findings can be beneficial for investors and provide further evidence of the potential usefulness of the yield curve spreads as indicators of the future economic activity.