Previous literature that relates predictions of proxies for real economic activity to financial variables has focused mainly on the information from the government debt market, the corporate debt market and the stock market. The prominent financial leading indicators for policy makers are the inverse of the slope of the nominal yield curve (e.g., term spread, defined as the difference between the 10-year Treasury bill rate and the 3-month Treasury bill rate), the paper-bill spread (defined as the difference between yields on the commercial paper and the Treasury bill) and the return on stock market indices.

It has been documented that these financial indicators have lost considerable forecasting power in recent years. More specifically, a worsening in the term spread predictive content regarding the US recession in the early 1990s has been documented by Haubrich and Dombrosky (1996) and Dotsey (1998). More recently, Stock and Watson (2003b) find that although the term spread did turn negative in advance of the 2001 recession, this inversion, however, was small by historical standards. Furthermore, the study of Friedman and Kuttner (1998) shows a poor forecasting performance of the paper-bill spread. Finally, Fama (1981) and Harvey (1989) show that the linkage between stock market indicators and output growth is unclear, while Stock and Watson (1989, 1999) and Estrella and Mishkin (1998) find evidence of little marginal forecasting content in stock prices.