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ROC approach to forecasting recessions using daily yield spreads.

Kajal Lahiri1, Cheng Yang2

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Business Economics (Cleveland, Ohio)
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The yield spread is a key recession indicator, but its predictive power has declined. Using the Receiving Operating Characteristics (ROC) approach, this study finds that adjusting for an upward-drifting optimal threshold restores its forecasting ability.

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Area of Science:

  • Economics
  • Financial Markets
  • Econometrics

Background:

  • The relationship between GDP growth and yield spreads has shown structural breaks and declining predictability.
  • Despite these instabilities, the yield spread inversion remains a closely watched leading indicator for recessions by business analysts.

Purpose of the Study:

  • To reevaluate the forecasting power of the yield spread for recessions using the Receiving Operating Characteristics (ROC) approach.
  • To identify optimal thresholds for the yield spread to maximize its discriminatory power in recession forecasting.
  • To account for temporal instabilities in the yield spread-recession relationship.

Main Methods:

  • Utilized the Receiving Operating Characteristics (ROC) approach to assess the predictive power of yield spreads.
  • Analyzed historical data from January 2, 1962, to identify optimal cut-off values.
  • Evaluated discriminatory power using ROC curve functionals like hit rate, false alarm rate, and Youden's index.

Main Results:

  • The optimal threshold for the yield spread has drifted upwards from zero since the early 1980s.
  • The declining predictive power of the yield spread can be largely restored by employing these identified optimal cut-off values.
  • The ROC analysis quantifies the trade-offs between hit rates and false alarm rates for different spread thresholds.

Conclusions:

  • The yield spread remains a valuable, albeit evolving, indicator for recession forecasting.
  • Adjusting recession forecasts based on the time-varying optimal yield spread threshold is crucial for maintaining predictive accuracy.
  • The ROC methodology provides a robust framework for recalibrating financial leading indicators in the presence of structural changes.