The term structure of interest rates and the Mexican economy

DANIEL T. WALZ [*] I. INTRODUCTION Can the yield spread, which has been found to predict with surprising accuracy the movement of key macroeconomic variables of developed countries, also predict such variables for a developing country experiencing economic turmoil? This article presents empirical results that suggest significant forecasting ability for the yield spread for segments of the Mexican economy during the 1995-1997 period of economic volatility. The actual and predicted variable changes sometimes conflict with those experienced by developed countries in part because of the unusually close relationship between the Mexican Treasury and the Banco de M[acute{e}]xico. Consequently, analysts and policy officials may exploit the forecast potential of the yield spread, but only in the context of evolving institutional considerations. (JEL 054, E44, F37) In recent years, financial scholars have uncovered a remarkably powerful and simple predictive instrument described as the yield spread, or term structure of interest rates. Most of the research has been directed toward elements of the U.S. economy, although some studies of other developed countries have begun to emerge. Yield spread studies of developing countries are rare, due in part to the presence of institutional dissimilarities and availability of reliable data. The yield spread has been found to predict with surprising accuracy future movements in interest rates, economic growth, inflation, and even selected components of GDP. The vast majority of the empirical tests have been conducted in an environment of economically stable institutions during relatively stable times. A more interesting challenge might be to subject yield spread predictive power to the following extreme test: a developing country during a period of radical economic volatility. Specifically, this article examines the predictive content of the term spread for several economic variables of the Mexican economy during the 1991-1997 period. Mexico experienced relative economic stability in the early 1990s, and economic turmoil following the shock of the peso devaluation in late December 1994. The variables to which the yield spread will be related are future changes in prices, industrial production, the peso/dollar exchange rate, and imports. The findings presented here, in brief, are that the yield spread demonstrates its predictive power in application to the Mexican economy (1) with special force during the period of greatest turmoil and (2) in somewhat unusual ways, in consonance with Mexican institutional configurations. Following this introduction, selected yield spread literature is discussed in section II and an overview of the Mexican economy and institutions is presented in section III. The model and associated equations are developed in section IV and empirical findings are discussed in section V. The conclusions of the paper are presented in section VI. II. SELECTED YIELD SPREAD LITERATURE Numerous analysts have examined the informational content of the term structure, or yield spread, for future movements in interest rates. The yield spread may be defined as the difference between yields on two different government debt securities, one of short-term maturity and the other of a longer-term. A testable hypothesis that emerges from the relation between the yield spread and future rate movements is that forward interest rates (which can be calculated from the yield spread) predict future spot rates. Sometimes described as the pure expectations hypothesis (PEH), its predictive content may be tracked either by examining whether the current difference between forward and current rates forecasts the subsequent change in rates or by testing the predictive ability of current yield spreads for subsequent changes in rates. Those who failed to obtain confirmation of the PEH include Ilamen (1996), Elton et al. (1996), and Young and Fowler (1990). …