Abstract: We estimate a model that summarizes the yield curve using latent factors (specifically, level, slope, and curvature) and also includes observable macroeconomic variables (specifically, real activity, inflation, and the monetary policy instrument). Our goal is to provide a characterization of the dynamic interactions between the macroeconomy and the yield curve. We find strong evidence of the effects of macro variables on future movements in the yield curve and evidence for a reverse influence as well. We also relate our results to the expectations hypothesis.

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This paper quantifies how variation in real economic activity and inflation in the U.S. influenced the market prices of level, slope, and curvature risks in U.S. Treasury markets. To accomplish this we develop a novel arbitrage-free DT SM in which macroeconomic risks – in particular, real output and inflation risks – impact bond investment decisions separately from information about the shape of the yield curve. Estimates of our preferred macro-DT SM over the twenty-three year period from 1985 through 2007 reveal that unspanned macro risks explained a substantial proportion of the variation in forward terms premiums. Unspanned macro risks accounted for nearly 90 % of the conditional variation in short-dated forward term premiums, with unspanned real economic growth being the key driving factor. Over horizons beyond three years, these effects were entirely attributable to unspanned inflation. Using our model, we also reassess some of Chairman Bernanke’s remarks on the interplay between term premiums, the shape of the yield curve, and macroeconomic activity.

In 2004 and 2005, long-term interest rates remained remarkably low despite improving economic conditions and rising short-term interest rates, a situation that then-Federal Reserve Board Chairman Alan Greenspan dubbed a “conundrum. ” We document the extent and timing of this conundrum using two empirical no-arbitrage macro-finance models of the term structure of interest rates. These models confirm that the recent behavior of long-term yields has been unusual—that is, it cannot be explained within the framework of the models. Therefore, we consider other macroeconomic factors omitted from the models and find that some of these variables, particularly declines in long-term bond volatility, may explain a portion of the conundrum. Foreign official purchases of U.S. Treasuries appear to have played little or no role.

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We examine the relationship between monetary-policy-induced changes in short interest rates and yields on long-maturity default-free bonds. The volatility of the long end of the term structure and its relationship with monetary policy are puzzling from the perspective of simple structural macroeconomic models. We explore whether richer models of risk premiums, speci cally stochastic volatility models combined with Epstein-Zin recursive utility, can account for these patterns. We study the properties of the yield curve when in ation is an exogenous process and compare this to the yield curve when in ation is endogenous and determined through an interest-rate/Taylor rule. We nd that the Epstein-Zin model with moderate risk aversion, persistent volatility of real endowment growth, and exogenous in ation, does a good job of matching the shape of the historical average yield curve. However, it exhibits less volatility in long rates than found in the data. We add to this environment a Taylor rule that raises the short interest rate aggressively in response to current in ation, and re-solve for yields using the endogenous equilibrium process for in ation. We nd that risk premiums increase

The basic inability of standard theoretical models to generate a sufficiently large and variable nominal bond risk premium has been termed the “bond premium puzzle.” We show that the term premium on long-term bonds in the canonical dynamic stochastic general equilibrium (DSGE) model used in macroeconomics is too small and stable relative to the data. We find that introducing long-memory habits in consumption as well as labor market frictions can help fit the term premium, but only by seriously distorting the DSGE model’s ability to fit other macroeconomic variables, such as the real wage; therefore, the bond premium puzzle remains.

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Alex Cukierman, Reinhard Tietz, and Todd Clark for which they are very grateful. Thanks also to Matthew Cardillo for excellent research assistance. Sharon Kozicki’s address is Federal Reserve Bank of Kansas City, 925 Grand Boulevard, Kansas City, MO. The views expressed are those of the authors and do not necessarily represent those of the Federal Reserve Bank of Kansas City or the Federal Reserve Board.