Term Spread Volatility as a Leading Indicator of Economic Activity

ABSTRACT In this paper, we examine the macroeconomic predictive power of the volatility of the US Treasury yield curve slope (term spread volatility). Our forecasting exercise shows that US term spread volatility has significant predictive power for US industrial production and employment growth. The predictive power of term spread volatility is stronger at medium‐ and long‐term forecasting horizons and remains robust when well‐established predictors of economic activity, such as the term spread and stock market returns, are included. Our results also show that term spread volatility has statistically and economically distinct predictive power compared to other measures of economic uncertainty. Moreover, the predictive power of term spread volatility increases significantly after the 2008 Great Recession, indicating that the relationship between uncertainty about macroeconomic expectations and macroeconomic performance has strengthened in the post–Great Recession period. Finally, our out‐of‐sample forecasting results show that term spread volatility outperforms the term spread in forecasting economic activity over the longer term.