Interest rate uncertainty and economic activity

Updated: Aug 30, 2019

Implied volatility from Treasury derivatives predicts macroeconomic and financial activity.  Treasury yield implied volatility is a useful forward-looking state variable that characterize risks in the macroeconomy (Presented at AEA Annual Meetings, Philadelphia, 2018).




We show that higher implied volatility from the Treasury derivatives market, a proxy for interest rate uncertainty, predicts declining macroeconomic activity and increased macroeconomic uncertainty. To the best of our knowledge, we are the first paper to show empirically that implied volatilities in the Treasury markets predict both the level and the volatility of several macroeconomic variables.

While many papers study the relation between many financial variables and real activity, there remains little agreement on which variables can consistently predict real activity, especially at horizons longer than one quarter (Stock and Watson (2003)). In addition, with a few exceptions such as Schwert (1989) and Bakshi, Panayotov, and Skoulakis (2011) this literature is largely silent on the links between financial markets and macroeconomic volatility.

The Treasury market is one of the largest and most liquid markets in the world. It serves as both a direct exchange for Treasury securities and a driver of many other financial securities issued by financial institutions and corporations. Therefore, a proxy for the level of interest rate uncertainty as implied from the Treasury derivatives market seems ex-ante a good candidate for predicting aggregate economic risk.


Interest rate volatility and economic activity.


Higher interest rate volatility predicts lower real activity as measured by growth rates of the gross domestic product (GDP), aggregate industrial production, aggregate consumption, and aggregate employment.

An increase in YIV is associated with a future increase in the volatility of growth rates of GDP, industrial production, consumption, and employment. We measure the unconditional volatility of GDP, industrial production, consumption, and employment using 12-month rolling windows.

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© 2019 by Priyank Gandhi.