Mind the (Convergence) Gap: Forward Rates Strike Back!
58 Pages Posted: 17 Mar 2012 Last revised: 31 Mar 2019
Date Written: March 29, 2019
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: Suggested Citation