Informational Content of Yield Spread: Predicting Economic Growth of Malaysia

Abstract

The predictive ability of the yield spread and its expectations-related (ER) and term premium (TP) components for economic activity in Malaysia is examined in the presence of interest rate volatility. Yield spread is defined as the interest differential of the 10-year Malaysian Government Security and 3-month Malaysian Government Treasury Bill (MTB). Interest rate volatility is modelled as a GARCH conditional variance model of the 3-month MTB yields. The results show that the yield spread is an empirically important predictor of economic activity. While this relationship is robust and stable across different forecast horizons, its predictability power becomes significant only at longer forecast horizons, highlighting its importance after the exhaustion of short-term information contained in the other variables indicative of monetary policy
stance. Of the two components, the ER term has significant informational content for explaining variations in economic activity. The TP term, however, is insignificant over all forecasting horizons. The interest rate volatility also has relevance for the yield spread’s predictive ability in economic growth forecasts.