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A rotated Dynamic Factor Model for the yield curve: squeezing out information when it matters

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  • Casoli, Chiara
  • Lucchetti, Riccardo

Abstract

The yield curve is widely regarded as a powerful descriptor of the economy and market expectations. A common approach to its statistical representation relies on a small number of factors summarizing the curve, which can then be used to forecast real economic activity. We argue that optimal factor extraction is crucial for retrieving information when considering an approximate factor model. By introducing a rotation of the model including cointegration, we reduce cross-sectional dependence in the idiosyncratic components. This leads to improved forecasts of key macroeconomic variables during periods of economic and financial instability, both in the US and the euro area.

Suggested Citation

  • Casoli, Chiara & Lucchetti, Riccardo, 2026. "A rotated Dynamic Factor Model for the yield curve: squeezing out information when it matters," FEEM Working Papers 388985, Fondazione Eni Enrico Mattei (FEEM).
    • Handle: RePEc:ags:feemwp:388985
    DOI: 10.22004/ag.econ.388985
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    Keywords

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    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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