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Predictions of short-term rates and the expectations hypothesis of the term structure of interest rates

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Author Info
Massimo Guidolin () (Federal Reserve Bank of St. Louis, 411 Locust St, St Louis, MO, 63166-0442, USA.)
Daniel L. Thornton () (Federal Reserve Bank of St. Louis, 411 Locust St, St Louis, MO, 63166-0442, USA.)

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Abstract

Despite its important role in monetary policy and finance, the expectations hypothesis (EH) of the term structure of interest rates has received virtually no empirical support. The empirical failure of the EH was attributed to a variety of econometric biases associated with the single-equation models used to test it; however, none account for it. This paper analyzes the EH by focusing on its fundamental tenet - the predictability of the short-term rate. This is done by comparing h-month ahead forecasts for the 1- and 3-month Treasury yields implied by the EH with the forecasts from random-walk, Diebold and Lei (2006), and Duffee (2002) models. The evidence suggests that the failure of the EH is likely a consequence of market participants’ inability to predict the short-term rate. JEL Classification: E40, E52.

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Paper provided by European Central Bank in its series Working Paper Series with number 977.

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Length: 30 pages
Date of creation: Dec 2008
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Handle: RePEc:ecb:ecbwps:20080977

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Related research
Keywords: Expectations theory; random walk; time-varying risk premium;

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This paper has been announced in the following NEP Reports: References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Tzavalis, Elias & Wickens, Michael R, 1997. "Explaining the Failures of the Term Spread Models of the Rational Expectations Hypothesis of the Term Structure," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(3), pages 364-80, August.
  2. Francis X. Diebold, & Glenn D. Rudebusch & S. Boragan Aruoba, 2003. "The Macroeconomy and the Yield Curve: A Nonstructural Analysis," CFS Working Paper Series 2003/31, Center for Financial Studies. [Downloadable!]
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  3. William Poole & Robert H & Rasche & Daniel L. Thornton, 2002. "Market anticipations of monetary policy actions," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 65-94. [Downloadable!]
  4. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02. [Downloadable!] (restricted)
  5. Bekaert, Geert & Hodrick, Robert J. & Marshall, David A., 2001. "Peso problem explanations for term structure anomalies," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 241-270, October. [Downloadable!] (restricted)
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  6. Francis X. Diebold & Canlin Li, 2003. "Forecasting the Term Structure of Government Bond Yields," NBER Working Papers 10048, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. Michael Dotsey & Christopher Otrok, 1995. "The rational expectations hypothesis of the term structure, monetary policy, and time-varying term premia," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 65-81. [Downloadable!]
  8. Rudebusch, Glenn D., 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Journal of Monetary Economics, Elsevier, vol. 35(2), pages 245-274, April. [Downloadable!] (restricted)
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  9. Harvey, David & Leybourne, Stephen & Newbold, Paul, 1997. "Testing the equality of prediction mean squared errors," International Journal of Forecasting, Elsevier, vol. 13(2), pages 281-291, June. [Downloadable!] (restricted)
  10. Balduzzi, Pierluigi & Bertola, Giuseppe & Foresi, Silverio, 1997. "A model of target changes and the term structure of interest rates," Journal of Monetary Economics, Elsevier, vol. 39(2), pages 223-249, July. [Downloadable!] (restricted)
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  11. Simon, David P, 1990. " Expectations and the Treasury Bill-Federal Funds Rate Spread over Recent Monetary Policy Regimes," Journal of Finance, American Finance Association, vol. 45(2), pages 467-77, June.
  12. Geert Bekaert, 2001. "Expectations Hypotheses Tests," Journal of Finance, American Finance Association, vol. 56(4), pages 1357-1394, 08. [Downloadable!] (restricted)
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  13. Campbell, John Y & Shiller, Robert J, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Review of Economic Studies, Blackwell Publishing, vol. 58(3), pages 495-514, May. [Downloadable!] (restricted)
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  14. Campbell, John Y & Shiller, Robert J, 1987. "Cointegration and Tests of Present Value Models," Journal of Political Economy, University of Chicago Press, vol. 95(5), pages 1062-88, October. [Downloadable!] (restricted)
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  15. Carriero, Andrea & Favero, Carlo A & Kaminska, Iryna, 2004. "Financial Factors, Macroeconomic Information and the Expectations Theory of the Term Structure of Interest Rates," CEPR Discussion Papers 4301, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  16. Hardouvelis, Gikas A., 1994. "The term structure spread and future changes in long and short rates in the G7 countries: Is there a puzzle?," Journal of Monetary Economics, Elsevier, vol. 33(2), pages 255-283, April. [Downloadable!] (restricted)
  17. Harvey, David I & Leybourne, Stephen J & Newbold, Paul, 1998. "Tests for Forecast Encompassing," Journal of Business & Economic Statistics, American Statistical Association, vol. 16(2), pages 254-59, April.
  18. Daniel L. Thornton, 2004. "Testing the expectations hypothesis: some new evidence for Japan," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 21-40. [Downloadable!]
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  19. Dai, Qiang & Singleton, Kenneth J., 2002. "Expectation puzzles, time-varying risk premia, and affine models of the term structure," Journal of Financial Economics, Elsevier, vol. 63(3), pages 415-441, March. [Downloadable!] (restricted)
  20. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," Journal of Business, University of Chicago Press, vol. 60(4), pages 473-89, October. [Downloadable!] (restricted)
  21. Roberds, William & Whiteman, Charles H., 1999. "Endogenous term premia and anomalies in the term structure of interest rates: Explaining the predictability smile," Journal of Monetary Economics, Elsevier, vol. 44(3), pages 555-580, December. [Downloadable!] (restricted)
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  22. Hardouvelis, Gikas A, 1988. " The Predictive Power of the Term Structure during Recent Monetary Regimes," Journal of Finance, American Finance Association, vol. 43(2), pages 339-56, June. [Downloadable!] (restricted)
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  23. Diebold, Francis X & Mariano, Roberto S, 1995. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(3), pages 253-63, July.
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Silva Lopes, Artur C. & Monteiro, Olga Susana, 2007. "The Expectations Hypothesis of the Term Structure: Some Empirical Evidence for Portugal," MPRA Paper 6310, University Library of Munich, Germany, revised 14 Dec 2007. [Downloadable!]
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  2. Silva Lopes, Artur C. B. da & Monteiro, Olga Susana, 2008. "Short and long run tests of the expectations hypothesis: the Portuguese case," MPRA Paper 12001, University Library of Munich, Germany. [Downloadable!]
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