A No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic and Latent Variables

Abstract

This paper describes the joint dynamics of bond yields and macroeconomic variables in a Vector Autoregression, where identifying restrictions are based on the absence of arbitrage. Using a term structure model with inflation and economic growth factors, we investigate how macro variables affect bond prices and the dynamics of the yield curve. The setup accommodates higher order autoregressive lags for the macro factors. The macro variables are augmented by traditional unobserved term structure factors. We find that the forecasting performance of a VAR improves when no-arbitrage restrictions are imposed. Models that incorporate macro factors forecast better than traditional term structure models with only unobservable factors. Variance decompositions show that macro factors explain up to 85% of the variation in bond yields. Macro factors primarily explain movements at the short end and middle of the yield curve while unobservable factors still account for most of the movement at the long end of the yield curve.