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Interest Rate Volatility and Expectations about the Business Cycle

One explanation for the usefulness of financial variables as tools for economic forecasting is that they embody the expectations of economic agents about the future state of the economy. In this paper, we test whether interest rate volatility contains information on the expectations of agents which are directly measured by confidence indicators. For the sake of robustness, we use several different expectation indicators for the two countries we analyze, the US and Germany: the Conference Board Consumer Confidence Index, the Philadelphia Fed’s Business Outlook Survey and the Purchase Management Index for the US and the Economic Sentiment Indicator, the IFO Business Climate and ZEW Indicator of Economic Sentiment for 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.