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Bond returns and market expectations

Author

Listed:
  • Carlo Altavilla

    (Institute for Fiscal Studies)

  • Riccardo Costantini

    (Institute for Fiscal Studies)

  • Raffaella Giacomini

    () (Institute for Fiscal Studies and cemmap and UCL)

Abstract

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 a 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 and robust across a number of maturities and forecast horizons. The method would have allowed an investor to obtain positive cumulative excess returns from simple "riding the yield curve" investment strategies over the past ten years, and in this respect it would have outperformed its competitors even after accounting for a risk-return tradeoff.

Suggested Citation

  • Carlo Altavilla & Riccardo Costantini & Raffaella Giacomini, 2013. "Bond returns and market expectations," CeMMAP working papers CWP20/13, Centre for Microdata Methods and Practice, Institute for Fiscal Studies.
  • Handle: RePEc:ifs:cemmap:20/13
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    File URL: http://www.cemmap.ac.uk/wps/cwp201313.pdf
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Giacomini, Raffaella, 2014. "Economic theory and forecasting: lessons from the literature," CEPR Discussion Papers 10201, C.E.P.R. Discussion Papers.
    2. Davide Pettenuzzo & Antonio Gargano & Allan Timmermann, 2014. "Bond Return Predictability: Economic Value and Links to the Macroeconomy," Working Papers 75, Brandeis University, Department of Economics and International Businesss School.
    3. Vieira, Fausto & Fernandes, Marcelo & Chague, Fernando, 2017. "Forecasting the Brazilian yield curve using forward-looking variables," International Journal of Forecasting, Elsevier, vol. 33(1), pages 121-131.
    4. Fausto Vieira & Fernando Chague, Marcelo Fernandes, 2016. "A dynamic Nelson-Siegel model with forward-looking indicators for the yield curve in the US," Working Papers, Department of Economics 2016_31, University of São Paulo (FEA-USP).
    5. Raffaella Giacomini, 2014. "Economic theory and forecasting: lessons from the literature," CeMMAP working papers CWP41/14, Centre for Microdata Methods and Practice, Institute for Fiscal Studies.

    More about this item

    Keywords

    Yield curve modelling; futures; market timing; exponential tilting; Kullback-Leibler;

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling

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