Bond Returns and Market Expectations

A well-documented empirical result is that market expectations extracted from futures contracts on the federal funds rate are among the best predictors for the future course of monetary policy. We show how this information can be exploited to produce accurate forecasts of bond excess returns and to construct profitable investment strategies in bond markets. We use an exponential tilting method for incorporating market expectations into forecasts from a standard term-structure model and then derive the implied forecasts for bond excess returns. We find that the method delivers substantial improvements in out-of-sample accuracy relative to a number of benchmarks. The accuracy improvements are both statistically and economically significant for bond maturities of up to two years and forecast horizons less than one year, and would have allowed an investor to obtain positive cumulative excess returns from simple "riding the yield curve" investment strategies over the past ten years. For long forecast horizons and bond maturities of four or five years, the preferred forecast is instead one implied by a simple autoregressive model.