How does the yield curve perform out of sample, and can it be supplemented with other indicators?
A. The yield curve performs quite well in out of sample tests of predictive accuracy, and it is not clear that, in general, supplementary information can improve its predictive performance. Estrella and Mishkin (1998) find that, at predictive horizons beyond one quarter, there is no match for the term structure as a predictor of recessions. Not only do a large number of other indicators fall short, but predictions deteriorate as those other indicators are added to the term spread in out of sample forecasting exercises. Stock and Watson (2003) similarly examine a large number of competing indicators, but focus on forecasts of output growth rather than recessions. They find that the term spread works best, but that it exhibits some instability. The nature of this instability seems sufficiently idiosyncratic that combining the term spread with some other indicators may improve performance in their equations.
