FNCE 4070 Financial Markets and InstitutionsDownward Sweeping or Inverted Yield Curve And Economic ActivityInterest Rates and Business Cycles: 1969 – 1983Interest Rate Spreads and Business Cycles: 1969 - 1983Interest Rates and Business Cycles: 1987 – 2011Interest Rate Spreads and Business Cycles: 1987 - 2011Evidence from AustraliaEvidence From the U.K.Yield Curves and Recessions: The EvidenceUsing Probit Analysis to Test the Probability of a Recession (Estrella and Trubin)Using Probit Analysis to Test the Predictive Value of the Yield Curve (Estralla and Mishkin)The Yield Curve and Interest Rate ForecastingForecasting with The Expectations TheoryForecasting With The Expectations Model: Example #1Yield Curve For Example #1Forecasting With The Expectations Model: Example #2Yield Curve For Example #2Using the Current Yield Curve Data to Forecast Interest RatesForecasting with the Liquidity Premium TheoryPredictions of Future Interest Rate Moves with the LP Model Note: Solid yield curve is observed and broken line is taking out positive LP. (a): Implied increase in forward rate greater than LP. (b): Implied increase in forward rate equal to LP . (c): Implied decrease in forward rate slightly greater than LP. (d): Implied decrease in forward rate much greater than LP.Forecasting Forward Rates with the Liquidity Premium TheoryEstimating the Liquidity Premium (Ln)Forecasting with the Liquidity Premium Theory: Example 1Forecasting with the Liquidity Premium Theory: Example 2Comparing Expectations and Liquidity Premium ForecastsAn Actual Interest Rate ForecastMarket Segmentations TheoryMarket Segmentations Theory: Explaining the Yield Curve Near the End of a Business ExpansionMarket Segmentations Yield Curve Near the End of an ExpansionForecasting with the Market Segmentations TheorySummary of Yield Curves and Business CyclesEstimating Future Rates of InflationU.S. Treasury Yield Curve Site for Observing Breakeven Rate of InflationAppendix 1Using Yield CurvesSlide 36Appendix 2Ben Bernanke Discusses the 2006 Yield CurveAppendix 3Mervyn Allister King Governor, Bank of EnglandJean-Claude Trichet President, ECBMasaaki Shirakawa Governor, Bank of JapanBen S. Bernanke, Governor, Federal ReserveFNCE 4070Financial Marketsand Institutions Lecture 5: Part 2Forecasting With the Term Structure of Interest Rates(1) Forecasting Business Cycle Turning Points (A Recession)(2) Forecasting Future Interest Rates (Estimating Forward Rates)(3) Estimating Future Rates of Inflation (Using TIPS)Downward Sweeping or Inverted Yield Curve And Economic ActivityInverted Yield Curve DiscussionInverted Yield Curve: An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered by some to be a predictor of an economic recession (i.e., business cycle turning point).Why: An inverted yield curve signals a future fall in interest rates which is consistent with a recession.Interest Rates and Business Cycles: 1969 – 1983Interest Rate Spreads and Business Cycles: 1969 - 1983Interest Rates and Business Cycles: 1987 – 2011Interest Rate Spreads and Business Cycles: 1987 - 2011Evidence from AustraliaEvidence From the U.K.Yield Curves and Recessions: The EvidenceSince the late 1980s, many researchers have provided evidence that the yield curve, or specifically the spread between long term and short term interest rates, has been a predictive signal of future recessions. They include:Arturo Estralla and Fredric Mishkin (June 1996), “The Yield Curve as a Predictor of U.S. Recession” (http://www.newyorkfed.org/research/current_issues/ci2-7.pdf), found that the yield curve outperformed other financial and economic indicators in predicting recessions, especially 2 to 3 quarters into the future.Arturo Estrella and Mary R. Trubin July/August 2006 ”The Yield Curve as a Leading Indicator: Some Practical Issues” http://www.newyorkfed.org/research/current_issues/ci12-5.pdf. Analyzed the yield spreads for six recessions from 1970 to 2001.Glenn D. Rudebusch and John C. Williams (July 2008), “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve”, found “that a simple model for predicting recessions that uses only real-time yield curve information would have produced better forecasts of recessions than professional forecasters”Using Probit Analysis to Test the Probability of a Recession (Estrella and Trubin)Using Probit Analysis to Test the Predictive Value of the Yield Curve (Estralla and Mishkin)The Yield Curve and Interest Rate ForecastingTwo of the yield curve theories are especially relevant for forecasting future interest rates. They are:Pure Expectations TheoryWhich assumes no liquidity premium for longer term debt instruments.Liquidity Preference TheoryWhich incorporates a liquidity premium for longer term debt instruments.Both of these theories involves the role of forward rates in setting spot rates.Thus we can arrange their formulas to calculate implied forward rates for any future period of time.Forecasting with The Expectations Theory Recall that the Expectations Theory assumes that the current long term spot interest rate is comprised of Current (spot) short term interest rate (iss) and Expected, future (forward) short-term interest rates (ie).If we assume the long term spot rate (ils) is an average of short term rates (iss and ie), it is possible to derive the “expected” forward rate (ie), on a one-period bond for some future time period (n-t) through the following formula:nieieieissilsntttn...21  111tnntnissilsieForecasting With The Expectations Model: Example #1 Assume the following:Current 1 year spot (iss1) = 5.0% Current 2 year spot (ils2) = 5.5% Use the formula on the previous slide to calculate the implied forward rate, or the 1year rate, 1 year from now: %00.60600.0105.01055.012 tnie  111tnntnissilsieYield Curve For Example #1Yield Curve The Forward RateThe calculated forward rate of 6.00% is the market’s expected 1 year interest rate one year from now.This rate of 6.00% becomes our forecasted interest rate using the pure expectations model. interest rate6.0% oie 5.5 oils25.0 oiss1 1y 2yTerm to