The yield curve and its forecasting potential : A review of empirical literature

Abstract: This paper demonstrates an overview of the empirical literature from the 1960s and onward as to why yield curve inversions are a leading recession forecasting indicator for the two to four-quarter forecasting horizon. This approach establishes a research framework within the delimitations of yield curve analysis and specifically, the effects of practical computational issues. Furthermore, this paper presents a macroeconomic dissection of the most influential variables affecting the yield curve such as the slope, curvature and level factors. In essence, this paper establishes a connection between our increasingly sophisticated understanding of monetary policy, which in turn allows the private sector to better calibrate and optimize their expectations in line of the stance of the monetary policy. Consequently, the role of these policy inventions gradually improved the credibility of financial institutions globally. The recent zero lower bound conditions in the money markets created a surge in liquidity, ultimately leading to a decrease in the risk premium component on the long end of the yield curve, even further tightening the yield spreads and flattening the yield curve.