Mind the (Convergence) Gap: Bond Predictability Strikes Back!
Forthcoming, Management Science
54 Pages Posted: 17 Mar 2012 Last revised: 5 Mar 2021
Date Written: August 1, 2020
We show that the difference between the natural rate of interest and the current level of monetary policy stance, which we label 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. Consistent with the argument that CG captures the effect of real imbalances on the path of rates, our factor has predictive ability for real bond excess returns. 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