A Macroeconomic Approach to the Term Premium

Abstract

In recent years, term premia have been very low and sometimes even negative. Now, with the United States economy growing above potential, inflationary pressures are on the rise. Term premia are very sensitive to the expected future path of growth, inflation, and monetary policy, and an inflation surprise could require monetary policy to tighten faster than anticipated, inducing to a sudden decompression of term and other risk premia, thus tightening financial conditions. This paper proposes a semi-structural dynamic term structure model augmented with macroeconomic factors to include cyclical dynamics with a focus on medium-to long-run forecasts. Our results clearly show that a macroeconomic approach is warranted: While term premium estimates are in line with those from other studies, we provide (i) plausible, stable estimates of expected long-term interest rates and (ii) forecasts of short-and long-term interest rates as well as cyclical macroeconomic variables that are stunningly close to those generated from large-scale macroeconomic models.

Reading the Stars

“…The contemporaneous estimate of the neutral real federal funds rate is modestly negative (which is well below that found in most other studies). This longrun decline is consistent with market-based results from most term premium models (see Adrian et al, 2013;Kim and Wright, 2005;and Kopp and Williams, 2018).…”

Natural Rate Chimera and Bond Pricing Reality

“…More specifically, our paper adds to those contributions that not only infer the natural short rate but the whole natural yield curve. Within those papers, we are the first -to the best of our knowledge -to estimate jointly a semi-structural macroeconomic system and an arbitrage- The paper most closely related to our work is Kopp and Williams (2018), yet their approach differs in several aspects. Firstly, the authors choose a model specification in which they re-place output and its gap measure with unemployment.…”

Natural Rate Chimera and Bond Pricing Reality

“…Within those papers, we are the first -to the best of our knowledge -to estimate jointly a semi-structural macroeconomic system and an arbitragefree affine term structure model. By contrast, Brzoza-Brzezina and Kotłowski (2014); Imakubo et al (2018); Kopp and Williams (2018); Dufrénot et al (2019) all follow a multi-step approach in which yield curve factors are treated as observables. Moreover, Brzoza-Brzezina and Kotłowski (2014); Imakubo et al (2018) and Dufrénot et al (2019) do not provide term-premia estimates.…”