Mind the (Convergence) Gap: Forward Rates Strike Back!

56 Pages Posted: 17 Mar 2012 Last revised: 25 Nov 2018

See all articles by Andrea Berardi

Andrea Berardi

Ca Foscari University of Venice - Dipartimento di Economia

Michael Markovich

Investment Strategy - Private Banking Wealth Management; Vienna Institute of Finance

Alberto Plazzi

Swiss Finance Institute; USI Lugano; Swiss Finance Institute

Andrea Tamoni

London School of Economics & Political Science (LSE)

Date Written: October 5, 2018

Abstract

Variation in expected yield changes contaminates bond risk premia information that is contained in forward rates. We show that the difference between the natural rate of interest and the current level of monetary policy stance, dubbed Convergence Gap (CG), forecasts changes in yields and helps identify whether forward rates reflect expectations of future interest rates or risk premia. Compared to a model with only forward rates, adding the CG significantly raises the $R^2$ in the forecasting regression of bond excess returns and delivers bond risk premia that are more countercyclical. The importance of CG remains robust out-of-sample, and in countries other than the U.S. Further, its inclusion brings significant economic gains in the context of dynamic conditional asset allocation. Overall, our results underscore the importance of revisions in monetary policy for bond predictability.

Keywords: Bond risk premia, Forward rates, Monetary policy, Natural rate of interest, Bond Predictability

JEL Classification: E0, E43, G0, G12

Suggested Citation

Berardi, Andrea and Markovich, Michael and Plazzi, Alberto and Tamoni, Andrea, Mind the (Convergence) Gap: Forward Rates Strike Back! (October 5, 2018). Available at SSRN: https://ssrn.com/abstract=2023885 or http://dx.doi.org/10.2139/ssrn.2023885

Andrea Berardi

Ca Foscari University of Venice - Dipartimento di Economia ( email )

Cannaregio 873
Venice, 30121
Italy

Michael Markovich

Investment Strategy - Private Banking Wealth Management ( email )

CRTI 4
P.O. Box
Zurich, CH-8070
Switzerland

Vienna Institute of Finance ( email )

Nordbergstrasse 15
Vienna, 1090
Austria

Alberto Plazzi (Contact Author)

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

USI Lugano ( email )

Via Buffi 13
CH-6900 Lugano
Switzerland

HOME PAGE: http://www.people.usi.ch/plazzia/

Swiss Finance Institute ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

Andrea Tamoni

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
02079557303 (Phone)

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