Forecasting and Trading Monetary Policy Effects on the Riskless Yield Curve with Regime Switching Nelson‐Siegel Models

67 Pages Posted: 10 Jan 2019 Last revised: 23 Jan 2019

See all articles by Massimo Guidolin

Massimo Guidolin

Bocconi University - Department of Finance

Manuela Pedio

Bocconi University - CAREFIN - Centre for Applied Research in Finance

Date Written: January 1, 2019

Abstract

We use monthly data on the US riskless yield curve for a 1982-2015 sample to show that mixing simple regime switching dynamics with Nelson-Siegel factor forecasts from time series models extended to encompass variables that summarize the state of monetary policy, leads to superior predictive accuracy. Such spread in forecasting power turns out to be statistically significant even controlling for parameter uncertainty and sample variation. Exploiting regimes, we obtain evidence that the increase in predictive accuracy is stronger during the Great Financial Crisis in 2007-2009, when monetary policy underwent a significant, sudden shift. Although more caution applies when transaction costs are accounted for, we also report that the increase in predictive power owed to the combination of regimes and of monetary variables that capture the stance of unconventional monetary policies is tradeable. We devise and test butterfly strategies that trade on the basis of the forecasts from the models and obtain evidence of risk-adjusted profits both per se and in comparisons to simpler models.

Keywords: Term structure of interest rates, Dynamic Nelson-Siegel factors, regime switching, butterfly strategies, unconventional monetary policy.

Suggested Citation

Guidolin, Massimo and Pedio, Manuela, Forecasting and Trading Monetary Policy Effects on the Riskless Yield Curve with Regime Switching Nelson‐Siegel Models (January 1, 2019). BAFFI CAREFIN Centre Research Paper No. 2019-106. Available at SSRN: https://ssrn.com/abstract=3313472 or http://dx.doi.org/10.2139/ssrn.3313472

Massimo Guidolin (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Manuela Pedio

Bocconi University - CAREFIN - Centre for Applied Research in Finance ( email )

Via Sarfatti, 25
Milan, 20136
Italy

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