Predicting real growth and the probability of recession in the Euro area using the yield spread

Although the spread has been established as a leading indicator of economic activity, recent studies in US and European Union (EU) countries have documented, theoretically and empirically, that the term spread–output growth relationship may not be stable over time and it may be subjected to nonlinearities. Using aggregate data for the Euro area over the period 1970:1–2000:4, we applied linear regression as well as nonlinear models to examine the predictive accuracy of the term spread–output growth relationship. Our results confirm the ability of the yield curve as a leading indicator. Moreover, significant nonlinearity with respect to time and past annual growth is detected, outperforming the linear model in out-of-sample forecasts of 1-year-ahead annual growth. Furthermore, probit models that use the EMU and US yield spreads are successful in predicting EMU recessions.