Forecasting economic activity from yield curve factors

• We decompose the yield curve into the slope and curvature factors.
• These factors contain more information on economic activity than yield slope.
• The slope factor contains information about future business cycle conditions.
• The curvature factor captures independent changes in current monetary policy.
• The out of sample performance of the model confirms our in sample results.

This paper provides clear-cut evidence that the slope and curvature factors of the term structure of interest rates (yield curve) contain more information about future changes in economic activity than the term spread itself, often used in the literature as a predictive regressor of economic activity. These two factors reflect different information about future economic activity, which is smoothed out by the term spread. The paper shows that the slope factor has predictive power on future economic activity over longer horizons ahead, and thus may be interpreted as reflecting future business cycle conditions. On the other hand, the curvature factor, which enters the term spread with opposite sign than the slope factor, has predictive power on shorter movements of future economic activity which may be associated with changes in the current stance of monetary policy. These results hold for a number of world developed economies.