Predictability of Interest Rates and Interest-Rate Portfolios

Abstract

Due to the near unit-root behavior of interest rates, the movements of individual interest-rate series are inherently difficult to forecast. In this paper, we propose an innovative way of applying dynamic term structure models to forecast interest-rate movements. Instead of directly forecasting the movements based on the estimated factor dynamics, we use the dynamic term structure model as a decomposition tool and decompose each interest-rate series into two components: a persistent component captured by the dynamic factors, and a strongly mean-reverting component given by the pricing residuals of the model. With this decomposition, we form interest-rate portfolios that are first-order neutral to the persistent dynamic factors, but are fully exposed to the strongly mean-reverting residuals. We show that the predictability of these interest-rate portfolios is significant both statistically and economically, both in sample and out of sample.

Keywords: Term structure, Predictability, Interest rates, Factors, Pricing errors, Expectation hypotheses

JEL Classification: E43, G11, G12, C51