The Term Spread as a Predictor of Financial Instability

The term spread is the difference between interest rates on short- and long-dated government securities. It is often referred to as a predictor of the business cycle. In particular, inversions of the yield curve—a negative term spread—are considered an early warning sign. Such inversions typically receive a lot of attention in policy debates when they occur. In this post, we point to another property of the term spread, namely its predictive ability for financial crisis events, both internationally and in historical U.S. data. We study the predictive power of the term spread for financial instability events in the United States and internationally over the past 150 years.