Yield curve, time varying term premia, and business cycle fluctuations

Using data for U.S. and Canada, we find evidence of the time-varying nature of risk premia, which are obtained as difference between long term interest rates and their expected values. We then apply Kalman filtering to extract the conditional variance of term premia prediction errors; our results highlight that this variable is informative beyond term premia and spreads, and it significantly improves upon prediction capability of standard models. In particular, the conditional variance of term premia, reflecting the high volatility of financial markets, anticipates movements in the output growth. Empirical evidence supports the inverse correlation between term premia and business cycle fluctuations. Data suggest that a deterioration of financial markets conditions, as captured by the increased volatility of term premia, anticipates a decline in the output growth. Therefore, term premia conditional volatility has an adverse effect on the economy.