Research Review | 16 June 2017 | Yield Curve Analysis

Monetary Policy Uncertainty and Bond Risk Premium
Fuwei Jiang (Central University of Finance and Economics) and
Guoshi Tong (Renmin University)

October 1, 2016
We show that uncertainty of monetary policy (MPU) commands a risk premium in the US Treasury bond market. Using the news based MPU measure in Baker, Bloom, and Davis (2016) to capture monetary policy uncertainty, we find that MPU forecasts significantly and positively future monthly Treasury bond excess returns. This forecastability remains significant controlling for standard bond risk premium predictors based on yield curve and macroeconomic fundamentals. The predictive power of MPU is not driven by uncertainty of economic growth, inflation and general economic condition, and is confirmed in out-of-sample tests.

Monetary Policy Surprises Over Time
Marcello Pericoli and Giovanni Veronese (Bank of Italy)
February 23, 2017
We document how the impact of monetary surprises in the euro area and the US on financial markets has changed since 1999. We use a definition of monetary policy surprises that singles out movements in the long end of the yield curve, rather than those that change nearby futures on the central bank reference rates. By focusing only on this component of monetary policy our results are more comparable over time. We find a hump-shaped response of the yield curve to monetary policy surprises, both in the pre-crisis period and since 2013. During the crisis years, Fed path-surprises, largely through their effect on term premia, account for the impact on interest rates, which is found to be increasing in tenor. In the euro area, the path-surprises reflect shifts in sovereign spreads and have a large impact on the entire constellation of interest rates, exchange rates and equity markets.

The Cross-Section of Government Bond Returns
Jordan Brooks (AQR Capital Management) and
Tobias J. Moskowitz (Yale and AQR Capital Management)

March 2017
We examine the cross-section of government bond returns using unique international data on tradable bonds. While the first three principal components fully describe yields in every market and share commonality across markets, excess bond returns are not explained by these factors. Rather, measures of value, momentum, and carry, which describe returns in other asset classes, provide a better description of bond risk premia, subsuming the principal components as well as factors that are unspanned by information in the yield curve, such as output growth and inflation. Intuitively, value measures yield levels relative to a fundamental anchor – expected inflation, momentum highlights recent yield trends, and carry captures expected future yields assuming the yield curve does not change. These three characteristics not only describe bond returns better than affine models or macroeconomic factors, but also provide a direct link to return predictability in other asset classes, suggesting a unifying framework for modeling asset risk premia

The Yield Curve Shape Dynamics and Real Economic Activity
Anqi Jiao and Jun Ma (University of Alabama)
January 14, 2017
We study the information in the yield curve. We find that the exponential decay term λ in the Nelson-Siegel model, which governs factor loadings, is informative the yield curve shape change. λ jumps high and becomes volatile from around 24 months before recessions, but subdued afterwards. The predictive power of λ, on economic recessions and output growths, is stronger than that of the yield spread and lagged growth rate, at horizons between 3 and 36 months. We also find that the information contained in the yield curve shape dynamics encompasses that in the yield spread alone.

Can Reinvestment Risk Explain the Dividend and Bond Term Structures?
Andrei S. Gonçalves (Ohio State University)
June 5, 2017
Contradicting leading asset pricing models, recent evidence indicates the term structure of dividend discount rates is downward sloping despite the typical upward sloping bond yield curve. This paper empirically shows that reinvestment risk explains both the dividend and bond term structures. Intuitively, dividend claims hedge equity reinvestment risk because dividend present values rise as expected returns decline. This hedge is more effective for longer-term dividend claims because they are more sensitive to discount rate variation, resulting in a downward sloping dividend term structure. For bonds, as expected equity returns decline, nominal interest rates rise, and bond prices fall. Consequently, bonds are exposed to equity reinvestment risk, and this exposure increases with duration, giving rise to an upward sloping bond term structure.

Using Macroeconomic Forecasts to Improve Mean Reverting Trading Strategies
Yash Sharma (The Cooper Union)
May 22, 2017
A large class of trading strategies focus on opportunities offered by the yield curve. In particular, a set of yield curve trading strategies are based on the view that the yield curve mean-reverts. Based on these strategies’ positive performance, a multiple pairs trading strategy on major currency pairs was implemented. To improve the algorithm’s performance, machine learning forecasts of a series of pertinent macroeconomic variables were factored in, by optimizing the weights of the trading signals. This resulted in a clear improvement in the APR over the evaluation period, demonstrating that macroeconomic indicators, not only technical indicators, should be considered in trading strategies.

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