LeadingIndicators

Goodforecastingisoftendeterminedby
findingleadingindicators variableswhich
reducetheMSEofmultistepforecasterrors
Leadingindicatorsmoveinadvanceofthe
forecastvariable
Economictheorycanbeagoodguidetohelp
selectleadingindicators

BusinessCycle
Measuresofthebusinesscycleinclude
GDPgrowth
Unemploymentrates
Productiongrowthrates

Alloftheserequireleadingindicatorsofthe
businesscycle

CommonLeadingIndicators

Housingstarts
Buildingpermits
Ordersforconsumergoods
Termspread(interestratespread)
DifferencebetweenLongRateandShortRate

JunkbondorHighYieldspread
Differencebetweenratesonlowgradeandhigh
gradebonds,typicallycorporate

U.S.TreasuryBonds
Highlyliquidmarket
U.S.Treasurybondsgenerallyviewedas
havingverylowdefaultrisk
Relativepuretermstructureanalysis.

TermSpread
Spread=LongShort
TermStructuretheory
LongRateisaverageofexpectedshortrates

Assetpricingtheory
LongBondshavegreaterrisk
Smallchangesinratesimplylargechangesinbondprice
Unlessyouholdbonduntilmaturitythereturnisuncertain

Riskyassetsreceiveariskpremium:higherexpected
returnsthanlowriskassets

Together,longratesshouldbehigherthanshortrates,
butareforecastsoffutureshortrates.
Thedifference thespread isaleadingindicator

U.S.Treasuary TermStructurein
March2014
Term(months)

Rate

Spread(over 3month)

0.05

0.08

0.03

12

0.13

0.208

60

1.64

1.59

120

2.72

2.67

InterestRateSpreads

SpreadandUnemploymentRate

TermInversion
Beforemanyrecessions,thelongratefell
belowtheshortrate
Thespreadbecamenegative
Themarketpricesalowerreturnonlongterm
bondsthanshorttermbonds
Calledatermstructureinversion
Signalsthatinvestorsexpectfallingshortrates
Negativespreadpredictsafuturerecession
Anincreaseintheunemploymentrate

Corporate/MunicipalBonds
Majormethodforcorporatefinancing
Apromisetopayinthefuture
Corporationsmaydefaultonbondpayments
intheeventofbankruptcy
Thisdefaultriskrequiresahigherinterestrate
RelativetolowriskTreasurybonds

Notallcorporationshaveequaldefaultrisk
Differentinterestrates

BondRatings

Creditratingagenciesassessdefaultriskofcorporationsand
otherborrowers,andgiveeacharating:
AAA,AA,A,BBB,BB,B,CCC,CC,C
Differentagenciesusesdifferentlabels

Highestrated(AAA)areviewedasnearzerodefaultrisk
Lowerratingmeanshigherdefaultrisk
GradeBBandlowerarecalled
Belowinvestorgrade
Highyield
Junk

Lowgradebondsearnhigherinterestrates
Higheraveragereturnstoinvestors
Higheraveragecoststocorporations
Higherriskofdefault

AAAandBAArates

JunkBondSpreadasLeadingIndicator
IdeaduetoMarkGertler and
CaraLown
Gertler isa1973UWgrad,
currentlyprofessoratNYU

Increasedjunkbondspreadis
afinancialsymptomofthe
businesscycle
Usefulleadingindicator
Onemeasure=BAA AAA

JunkBondSpread
Corporatebankruptciesaremorecommonineconomicdownturns
(recessions).Thusbonddefaultsaremorecommoninrecessions.
Ifinvestorsperceivetheriskofrecessionishigh,theywillviewhigh
yield(junk)bondsashighrisk,andonlyholdsuchbondsiftheir
interestrateincreases
But,highgradeandlowgradebondratesmoveupanddown
togetherasinterestratesriseandfall,sothelevelofhighyieldbond
ratesbyitselfisnotagoodsignalconcerningrecessionrisk
Instead,thespread(difference)betweentheinterestratesoflow
gradeandhighgrade(corporate)bondsisagoodsignal
Junkbondspread=RateonLowGrade RateonHighgrade
Weuse:Junk=BAA AAA
Theory:Thejunkspreadwillbepositivelyrelatedwitheconomic
downturns.

HighYieldSpreadandUnemploymentRate

Example:LeadingIndicatorsfor
UnemploymentRate
InterestRateSpreads
Spread120=T120T3(10yearsversus3month)
Spread60=T60T3(5yearsversus3month)
Spread12=T12T3(1yearversus3month)

HighYieldBondSpread
Junk=AAABAA

Allavailablestarting1953m4

LeadingIndicatorModel
Y=unemploymentrate
p autoregressivelags

X=interestratespread
qdistributedlags

yt = + 1 yt 1 + L + p yt p
+ 1 xt 1 + L + q xt q + et

Baseline
Tostart,weneedabaselineARmodelforthe
unemploymentrate
EstimateARmodels,order1to12

yt = + 1 yt 1 + L + p yt p + et

ARModelSelection
LowestAICattainedbyAR(6),with
AIC=445.5

UnemploymentRateonInterestRate
Spreads
Allregressionsinclude6autoregressivelags
Consider1to4lagsoninterestratespreads
X=LongRateminusShort(3month)Rate
10year
5year
1year

yt = + 1 yt 1 + L + p yt p
+ 1 xt 1 + L + q xt q + et

10yearspread

Allmodelsinclude6autoregressivelags
LowestAIChas3interestratespreadlags
AIC=448.5

LowerAICthanAR(6)alone

10yearspread

Include6autoregressivelags
Lag2coefficientpositive,Lag1&3negative
Increaseinspreadpredictsshorttermchangesin
unemployment,butnotinlongterm

5Year(60month)spread

NotaslowAICas10yearspread

1year(12month)spread

SlightlylowerAICthan10yearspreadregression
(AIC=451insteadofAIC=448.5)
Againlowobtainedbymodelwith3lags

1yearspread

Include6autoregressivelags
Lag2positive,Lag1andLag3negative
Increaseinspreadpredictsshorttermchangesin
unemployment,butnotinlongterm

HighYieldSpread

ConsiderablyLowerAIC
AIC=484insteadofAIC=451

LowestAICwith3distributedlags

HighYieldspread

Include6autoregressivelags
Lag1positive,Lag3negative,butsmaller
Increaseinhighyieldspreadpredictsshortterm
increaseinunemploymentwhichpersist

BothLong/ShortandHighYield Spread
Combinedmodel:
AR(6)inunemploymentratelates
3 lagsofJunkSpread(BAAoverAAA)
3lagsofSpread12(oneyearover3month)

AIC=490
Lowestachieved

Coefficients

12stepForecastRegression

ForecastInputs(March)
CurrentUnemploymentrate=6.7%
JunkSpread=0.68%
12monthspread=0.08%

reg urL(1/6).urL(1/3).spread12L(1/3).junkift>=tm(1954m4)
predicty1
predictsf1,stdf
geny1L=y11.645*sf1
geny1U=y1+1.645*sf1
reg urL(2/7).urL(2/4).spread12L(2/4).junkift>=tm(1954m4)
predicty2
predictsf2,stdf
geny2L=y21.645*sf2
geny2U=y2+1.645*sf2

egen p=rowfirst(y1y2y3y4y5y6y7y8y9y10y11y12)ift>=tm(2014m4)
egen pL=rowfirst(y1Ly2Ly3Ly4Ly5Ly6Ly7Ly8Ly9Ly10Ly11Ly12L)ift>=tm(2014m4)
egen pU=rowfirst(y1Uy2Uy3Uy4Uy5Uy6Uy7Uy8Uy9Uy10Uy11Uy12U)ift>=tm(2014m4)
labelvariablep"forecast"
labelvariablepL "lowerforecastinterval"
labelvariablepU "upperforecastinterval"
tsline urppL pU ift>=tm(2011m1),title(UnemploymentRate)lpattern (soliddashlongdash
shortdash)