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Interest Rates Under Falling Stars

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  • Michael D. Bauer
  • Glenn D. Rudebusch

Abstract

Macro-finance theory implies that trend ination and the equilibrium real interest rate are fundamental determinants of the yield curve. However, empirical models of the term structure of interest rates generally assume that these fundamentals are constant. We show that accounting for time variation in these underlying long-run trends is crucial for understanding the dynamics of Treasury yields and predicting excess bond returns. We introduce a new arbitrage-free model that captures the key role that long-run trends play in determining interest rates. The model also provides new, more plausible estimates of the term premium and accurate out-of-sample yield forecasts.

Suggested Citation

  • Michael D. Bauer & Glenn D. Rudebusch, 2017. "Interest Rates Under Falling Stars," CESifo Working Paper Series 6571, CESifo.
  • Handle: RePEc:ces:ceswps:_6571
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    Cited by:

    1. Breach, Tomas & D’Amico, Stefania & Orphanides, Athanasios, 2020. "The term structure and inflation uncertainty," Journal of Financial Economics, Elsevier, vol. 138(2), pages 388-414.
    2. James McNeil, 2020. "Estimation of Impulse response functions with term structure local projections," Working Papers daleconwp2020-05, Dalhousie University, Department of Economics.
    3. Nitschka, Thomas & Satkurunathan, Shajivan, 2021. "Habits die hard: implications for bond and stock markets internationally," VfS Annual Conference 2021 (Virtual Conference): Climate Economics 242358, Verein für Socialpolitik / German Economic Association.
    4. Michael D. Bauer & Glenn D. Rudebusch, 2020. "The Rising Cost of Climate Change: Evidence from the Bond Market," Working Paper Series 2020-25, Federal Reserve Bank of San Francisco.
    5. Richard K. Crump & Stefano Eusepi & Emanuel Moench & Bruce Preston, 2021. "The Term Structure of Expectations," Staff Reports 992, Federal Reserve Bank of New York.
    6. Schupp, Fabian & Geiger, Felix, 2018. "With a little help from my friends: Survey-based derivation of euro area short rate expectations at the effective lower bound," VfS Annual Conference 2018 (Freiburg, Breisgau): Digital Economy 181529, Verein für Socialpolitik / German Economic Association.
    7. Adam Kucera & Milan Szabo, 2019. "Estimating the neutral Czech government bond yield curve," Occasional Publications - Chapters in Edited Volumes,, Czech National Bank.
    8. Dąbrowski, Marek A., 2021. "A novel approach to the estimation of an actively managed component of foreign exchange reserves," Economic Modelling, Elsevier, vol. 96(C), pages 83-95.
    9. Doshi, Hitesh & Jacobs, Kris & Liu, Rui, 2018. "Macroeconomic determinants of the term structure: Long-run and short-run dynamics," Journal of Empirical Finance, Elsevier, vol. 48(C), pages 99-122.
    10. Bekaert, Geert & Engstrom, Eric & Ermolov, Andrey, 2021. "Macro risks and the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 141(2), pages 479-504.
    11. Nitschka, Thomas & Satkurunathan, Shajivan, 2021. "Habits die hard: implications for bond and stock markets internationally," VfS Annual Conference 2021 (Virtual Conference): Climate Economics 242358, Verein für Socialpolitik / German Economic Association.
    12. Bruno Feunou & Jean-Sébastien Fontaine, 2021. "Debt-Secular Economic Changes and Bond Yields," Staff Working Papers 21-14, Bank of Canada.
    13. Zongwu Cai & Jiazi Chen & Linlin Niu, 2021. "A Semiparametric Model for Bond Pricing with Life Cycle Fundamental," Working Papers 2021-01-06, Wang Yanan Institute for Studies in Economics (WISE), Xiamen University.
    14. Kučera, Adam, 2020. "Identification of triggers of U.S. yield curve movements," The North American Journal of Economics and Finance, Elsevier, vol. 54(C).
    15. Lange, Ronald Henry, 2018. "The term structure of liquidity premia and the macroeconomy in Canada: A dynamic latent-factor approach," International Review of Economics & Finance, Elsevier, vol. 57(C), pages 164-182.
    16. Dewundara Liyanage P. M. Rathnasingha & Kangara Pathirannehelage N. S. Dayarathne, 2021. "Constructing the Yield Curve for Sri Lankas Government Bond Market," International Journal of Business and Economic Affairs (IJBEA), Sana N. Maswadeh, vol. 6(1), pages 56-69.
    17. Zongwu Cai & Jiazi Chen & Linlin Liu, 2021. "Estimating Impact of Age Distribution on Bond Pricing: A Semiparametric Functional Data Analysis Approach," WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS 202102, University of Kansas, Department of Economics, revised Jan 2021.
    18. Saeed Zaman, 2021. "A Unified Framework to Estimate Macroeconomic Stars," Working Papers 202123, Federal Reserve Bank of Cleveland.

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    More about this item

    Keywords

    yield curve; macro-finance; inflation trend; equilibrium real interest rate; shifting endpoints; bond risk premia;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications

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