Dynamic probit models and financial variables in recession forecasting

In this paper, various financial variables are examined as predictors of the probability of a recession in the USA and Germany. We propose a new dynamic probit model that outperforms the standard static model, giving accurate out‐of‐sample forecasts in both countries for the recession period that began in 2001, as well as the beginning of the recession in 2008. In accordance with previous findings, the domestic term spread proves to be an important predictive variable, but stock market returns and the foreign term spread also have predictive power in both countries. In the case of Germany, the interest rate differential between the USA and Germany is also a useful additional predictor.