The expected bank profitability channel
In this paper, Minoiu et al. provide evidence that the term premium component of the yield curve slope predicts future economic activity through an expected profitability channel operating via bank lending, especially at leveraged banks. More specifically:
- Banks increase their lending and profitability following an unexpected rise in the term premium (the component of long-term interest rates that compensates for interest rate risk, distinct from expectations of future short rates).
- This effect is stronger for more leveraged (lower capital) banks, as predicted by a portfolio choice model for banks. A higher term premium raises the expected profitability of banks’ maturity transformation activities, incentivizing more lending, especially by leveraged banks with greater exposure to the term premium.
- Using detailed loan-level data, the authors show that around the 2013 Taper Tantrum episode, when term premiums rose sharply, lower capital banks were more likely to grant new loans, granted larger loans, and charged lower spreads compared to higher capital banks.
- Firms that borrowed more from leveraged banks before the Taper Tantrum had higher investment rates afterwards, suggesting the credit supply effects transmitted to the real economy.
- The results are robust to using different measures of term premiums, controlling for economic outlook forecasts, and employing instrumental variables and high-frequency shocks to identify exogenous movements in term premiums.
Why Does the Yield Curve Predict GDP Growth? The Role of Banks
Authors: Camelia Minoiu, Andres Schneider, Min Wei
From: Federal Reserve Bank of Atlanta, Board of Governors of the Federal Reserve System
The international spillover channel
In this paper, Ahmed and Chinn document the predictive power of foreign yield curves for the U.S. economy, distinct from the U.S. yield curve, and propose an international spillover channel through which this effect operates. They find that:
- Foreign term spreads (the difference between 10-year and 3-month sovereign bond yields) for non-U.S. G7 countries predict future U.S. recessions and GDP growth. A flattening of foreign term spreads signals higher U.S. recession risk and slower GDP growth.
- Foreign term spreads are stronger predictors of U.S. recessions occurring within the next year than the U.S. term spread itself. The U.S. term spread leads foreign term spreads but contains different predictive information over different horizons.
- A flattening U.S. term spread leads to a stronger U.S. dollar, while a flattening foreign term spread does not lead to significant U.S. dollar depreciation.
- A flattening foreign term spread predicts persistent declines in U.S. exports and lower foreign direct investment (FDI) inflows into the U.S., while the U.S. term spread does not have such effects.
- The findings suggest that foreign term spreads embed growth spillovers from the U.S. – a flattening U.S. yield curve spills over to foreign yield curves with a lag. The resulting stronger dollar and growth slowdown abroad then spill back to weaken U.S. exports and FDI inflows.
Do Foreign Yield Curves Predict U.S. Recessions and GDP Growth?
Authors: Rashad Ahmed, Menzie D. Chinn
From: U.S. Department of the Treasury, University of Wisconsin-Madison
