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This paper aims to examine the role of term spreads to predict domestic output and inflation in Malaysia, a country with a relatively less-developed bond market.

The paper uses regression time-series regressions and probit models that control for past values of the dependent variable to determine the forecast performance of term spread on inflation and output in Malaysia.

The paper finds that term spread contains little information about future output and inflation at short horizons. Moreover, the usefulness of term spread to play a greater role in monetary analysis beyond conventional indicators in the case of Malaysia is limited. The degree of usefulness of term spread impediment could be attributed to the relatively fragmented, illiquid and captive bond market characteristics as compared to what is available in more matured and developed markets.

It is useful to incorporate technical and model-based approaches using yield curves beyond the usual indicator analysis from the policy point of view. Models could be used in tandem with other monetary and financial indicators to support discussions on the direction of monetary policy.

An efficient bond market could also play an important role in propagating monetary impulses via the relevant monetary transmission channels. Based on the findings, the paper suggests that there is a strong case to deepen domestic bond market. This would greatly enhance price discovery among market participants, improve risk management away from the traditional source for funds (i.e. banking system) and address supply-related issues.