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Bond returns and market expectations

Listed author(s):
  • Carlo Altavilla

    (Institute for Fiscal Studies)

  • Riccardo Costantini

    (Institute for Fiscal Studies)

  • Raffaella Giacomini

    ()

    (Institute for Fiscal Studies and cemmap and UCL)

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.

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File URL: http://www.cemmap.ac.uk/wps/cwp201313.pdf
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Paper provided by Centre for Microdata Methods and Practice, Institute for Fiscal Studies in its series CeMMAP working papers with number CWP20/13.

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Date of creation: 24 May 2013
Handle: RePEc:ifs:cemmap:20/13
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  1. Laura Coroneo & Domenico Giannone & Michèle Modugno, 2013. "Unspanned Macroeconomic Factors in the Yields Curve," Working Papers ECARES ECARES 2013-07, ULB -- Universite Libre de Bruxelles.
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  11. Diebold, Francis X. & Rudebusch, Glenn D. & Borag[caron]an Aruoba, S., 2006. "The macroeconomy and the yield curve: a dynamic latent factor approach," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 309-338.
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