The Explanatory Power Of The Yield Curve In Predicting Recessions In South Africa

Abstract

The term structure of interest rates, particularly the term spreaddetermined from the difference between ten-year government bond yields andthree-month Treasury bill yields, has received increased attention as avaluable forecasting tool for the purposes of monetary policy and recessionforecasting. This is on the back of the observed positive relationship betweenterm spread and economic activity. Moreover, the term spread has been observedto invert prior to the occurrence of economic recessions both in developed anddeveloping countries.This study investigated the forecasting ability of the South African(S.A.) term spread in predicting S.A. recessions, taking into account therecent global economic recession. The motivation is due to the forecastingconsistencies illustrated by the term spread in providing statisticallyincorrect signals of recession in 2003, which did not transit into reality. Itimplied a weak relationship between the S.A. term spread and economic activity.Moreover, based on observations from the literature that term spreads andeconomic activities across countries are correlated, the term spreads of China,United States (U.S.) and Germany were investigated and compared to the S.A.term spread to determine which better forecasts S.A. recessions. The studyemployed the Dynamic Probit Model since it is considered to provide a betterpredictive edge over the Traditional Static Probit model.The findings revealed that the S.A. term spread accurately predicted allthe S.A recessions since 1980; Chinese term spread accurately predicted the1996 and 2008 S.A recessions; U.S. term spread predicted some recessions; whileGerman term spread predictions were counter-cyclical.