Abstract
While several studies focus on testing the predictive content of the yield curve, few explain why such predictive power prevails. Previous literature connects the root of the predictive content to monetary easing and market expectations. Following this path, this paper develops an SVAR model to investigate the dynamics among term spread, monetary surprises, and fluctuations in market expectations. Results reveal that between 1990 and 2019, the time for output growth to turn to zero due to yield curve shock has accelerated, indicating a growing predictive power. The impulse response of output growth implies the presence of a self-fulfilling prophecy. In response to surprises in monetary policy, the value of shorter-term securities is subject to great uncertainty. As market participants learn how yield curve inversion has succeeded in predicting recessions in the past, they hedge by positioning themselves for a recession as a yield curve inversion occurs. Gradually, the risk aversion propels the predictive content of the yield curve, effectively making it a self-fulfilling prophecy.