Interest rate volatility and business cycle expectations

Abstract

One explanation for the usefulness of financial variables as tools for economic forecasting is that they embody individual and firm expectations of future economic conditions. In this paper, we analyse whether interest rate volatility contains information on agent expectations which are directly measured by confidence indicators. For the sake of robustness, we use several different expectation indicators for the two countries we analyse, the US and Germany. We propose using a forward-looking measure of volatility: the implied volatility of one year cap options. We find that implied volatility adds explanatory power to the yield spread and to changes in the short rate, which are typical predictors of the business cycle, and outperforms realized volatility.