Mind the (Convergence) Gap: Bond Predictability Strikes Back!
58 Pages Posted: 17 Mar 2012 Last revised: 28 Sep 2019
Date Written: August 29, 2019
We show that the difference between the natural rate of interest and the current level of monetary policy stance, dubbed Convergence Gap (CG), contains information that is valuable for bond predictability. Adding CG in forecasting regressions of bond excess returns significantly raises the R-squared, and restores countercyclical variation in bond risk premia that is otherwise missed by forward rates. The convergence gap also predicts changes in future yields, and consistently plays the role of an unspanned variable within an affine term structure framework. The importance of the gap remains robust out-of-sample, and in countries other than the U.S. Furthermore, its inclusion brings significant economic gains in the context of dynamic conditional asset allocation.
Keywords: Bond Risk Premia, Forward Rates, Monetary Policy, Natural Rate of Interest, Bond Predictability
JEL Classification: E0, E43, G0, G12
Suggested Citation: Suggested Citation