The Forecasting Power of the Yield Curve, a Supervised Factor Model Approach

We study the forecast power of the yield curve for macroeconomic time series, such as consumer price index, personal consumption expenditures, producer price index, real disposable income, unemployment rate, and industrial production. We employ a state-space model in which the forecasting objective is included in the state vector. This amounts to an augmented dynamic factor model in which the factors (level, slope, and curvature of the yield curve) are supervised for the macroeconomic forecast target. In other words, the factors are informed about the dynamics of the forecast objective. The factor loadings have the Nelson and Siegel (1987) structure and we consider one forecast target at a time. We compare the forecasting performance of our specification to benchmark models such as principal components regression, partial least squares, and ARMA(p,q) processes. We use the yield curve data from G¨urkaynak, Sack, and Wright (2006) and Diebold and Li (2006) and macroeconomic data from FRED. We compare the models by means of the conditional predictive ability test of Giacomini and White (2006). We find that the yield curve has more forecast power for real variables compared to inflation measures and that supervising the factor extraction for the forecast target can improve forecast performance.