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Macro Risks and the Term Structure

date Date: May 7, 2015
date Author(s): Geert Bekaert, Eric Engstrom, Andrey Ermolov
date Affiliation: Columbia University - Board of Governors of the Federal Reserve System

We extract aggregate supply and demand shocks for the US economy from data on inflation and real GDP growth. Imposing minimal theoretical restrictions, we obtain identification through exploiting non-Gaussian features in the data. The risks associated with these shocks together with expected inflation and expected economic activity are the key factors in a tractable noarbitrage term structure model. Despite non-Gaussian dynamics in the fundamentals, we obtain closed-form solutions for yields as functions of the state variables. The time variation in the covariance between inflation and economic activity, coupled with their non-Gaussian dynamics leads to rich patterns in inflation risk premiums and the term structure. The macro variables account for over 70% of the variation in the levels of yields, with the bulk attributed to expected GDP growth and inflation. In contrast, macro risks predominantly account for the predictive power of the macro variables for excess holding period returns.


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