2017-16 | October 2019
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Interest Rates Under Falling Stars
Macro-finance theory implies that trend inflation and the equilibrium real interest rate are fundamental determinants of the yield curve. However, empirical models of the terms 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 for interest rates. The model also provides new, more plausible estimates of the term premium and accurate out-of-sample yield forecasts.
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Bauer, Michael D, and Glenn D. Rudebusch. 2017. "Interest Rates Under Falling Stars," Federal Reserve Bank of San Francisco Working Paper 2017-16. Available at https://doi.org/10.24148/wp2017-16