Predicting Recessions Using The Volatility Index And The Yield Curve

The yield curve is a graphical representation of the relationship between the yields of bonds with different maturities. The yield curve has been inverted before every recession in the United States since 1971, so it is often used as a predictor of recessions. Indeed, the spread between the long-term and the short-term interest rates has been found to be useful for forecasting recessions.

A new study [1] shows that the co-movement between the yield-curve spread and the VIX index, a measure of implied volatility in S&P500 index options, offers tremendous improvements in predicting U.S. recessions over the information in the yield-curve spread alone.

The scatter plot between the VIX index and the yield-curve spread reveals a countercyclical circle that repeatedly align with the business cycle. This paper uses this empirical observation to improve prediction of changes in the business cycle.

I construct a cycle indicator that summarizes the economy’s location on this VIX yield-curve cycle. The cycle indicator significantly outperforms other leading indicators in predicting U.S. recessions. The conclusion holds both in- and out-of-sample, and in both static and dynamic probit models. The predictive power comes from the interaction between monetary policy and corrections in financial markets rather than the co-movement between monetary policy and economic policy uncertainty. Using shadow rates, I find no evidence that the predictive power of the cycle indicator has weakened with the flattening yield curve and the use of unconventional monetary policy.

In short, the study concludes that the co-movement between the yield curve spread and the VIX index, which is a measure of implied volatility in S&P 500 index options, provides an improved prediction for U.S. recessions over any information available from just considering the yield-curve spreads alone. This new research will have implications on how macroeconomists forecast future economic conditions and could even change how we predict periods of high financial instability like the subprime crisis.

References

[1] Hansen, Anne Lundgaard, Predicting Recessions Using VIX-Yield-Curve Cycles (2021). https://ssrn.com/abstract=3943982

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