The information in the yield curve

Abstract

The term structure of interest rates as described by yield curves has the potential to contain information about the course of future nominal and real interest rates, inflation and economic activity. The link between the yield curve and these economic variables is formalised via capital asset pricing models. The information in yield curves is examined in a systematic manner using two new term structure data sets. The first one is an extended version of the McCulloch yield data for the United States for the period 1947-91 and the second one is a new highly detailed data set for the United Kingdom supplied by the Bank of England for this study, which consists of daily observations on yields for the period 4th January 1983 to 30th November 1993.Empirical evidence for the United States for the period 1952-91 shows that inflation and real interest rate changes tend to offset each other so that there is no useful information about nominal interest rates. Information about the real term structure is sometimes obscured by the offsetting effects of real interest rates and term premiums. Evidence is presented that shows yield spreads may give more unambiguous signals about economic activity if such activity is measured in relative terms. The better predictive power of UK term structures with regard to nominal interest rates is due to inflation and real interest rates moving together in the same direction. The phenomenon of disinflation can produce highly significant information about the real term structure. For the US and, more particularly, the UK, the predictive power of the yield curve is subject to significant change. The main conclusion reached is that over-reliance certainly should not be placed on the yield curve as a leading economic indicator.