The Effects of Conventional and Unconventional Monetary Policy on Forecasting the Yield Curve

55 Pages Posted: 8 May 2019

See all articles by Yunjong Eo

Yunjong Eo

The University of Sydney - School of Economics

Kyu H. Kang

Korea University

Date Written: April 3, 2019


The period of unconventional monetary policy in the low-interest rate environment since the Great Recession has suggested that unconventional policy has a different transmission mechanism to the term structure of interest rates from that of conventional policy. We study how conventional and unconventional monetary policies affect forecasting performance of individual yield curve models and their mixtures. The individual models considered here are the dynamic Nelson-Siegel model, the arbitrage-free Nelson-Siegel model, and the random-walk model. Out-of-sample forecasts for U.S. bond yields show that the arbitrage-free Nelson-Siegel model and its mixtures with other models perform well in the period of conventional monetary policy, whereas the random-walk model outperforms all the other models in the period of unconventional monetary policy. We show that the tightly constrained cross-equation restrictions of the no-arbitrage condition are associated with high correlations of bond yields across different maturities. The diminishing role of the no-arbitrage restriction in forecasting the yield curve since 2009 can be attributed to unconventional monetary policy, which involved direct purchases of long-term bonds while the short-term interest rates were stuck near zero. This policy resulted in low correlations between short- and long-term bond yields and little variation in the short-term bond yields. The random-walk model performs well when the yields are less correlated and exhibit little variation over time. During the period of the maturity extension program ("Operation Twist") in 2011--2012, which moved short- and long-term bond yields in opposite directions, the superiority of the random-walk forecasts is more pronounced; these results reinforce our finding that the monetary policy framework affects yield curve forecasts.

Keywords: Quantitative Easing; Operation Twist; Dynamic Nelson-Siegel Model; Arbitrage-Free Term Structure Model; Random-Walk Model; Markov-Switching Mixture

JEL Classification: C11; E43; E47; E52; G12

Suggested Citation

Eo, Yunjong and Kang, Kyu H., The Effects of Conventional and Unconventional Monetary Policy on Forecasting the Yield Curve (April 3, 2019). Available at SSRN: or

Yunjong Eo (Contact Author)

The University of Sydney - School of Economics ( email )

Social Sciences Building (A02)
Sydney, NSW 2006

Kyu H. Kang

Korea University ( email )

1 Anam-dong 5 ka
Seoul, 136-701

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