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 factors affect bond prices and the dynamics of the yield curve. Higher order autoregressive lags and moving-average error terms for macro factors are accommodated. The macro factors are augmented by traditional unobserved term-structure factors. Models that incorporate macro factors give better forecasts than traditional term-structure models with only unobservable factors. Variance decompositions show that macro factors explain up to 30\% 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 movement at the long end of the yield curve.