Expected Returns in Treasury Bonds

This research paper authored by Anna Cieslak and Pavol Povala was published back in 2015, and it had a significant impact on yield curve modelling research. The key contribution of the paper was to redirect the research on yield curve modelling towards a more macro-based approach. Up until that point, yield curve modelling was dominated by reduced-form affine term structure models. Their drawbacks included the inability to successfully relate yields to macro outlook, and to deal with persistent variables. This prevented affine term structure models from being widely adopted in practice. This state had persisted for a better part of two decades.

This paper provided a simple but robust solution to both issues by associating persistent movements in yields with long-horizon inflation expectations. As a consequence, most yield curve models today take persistent components of yields seriously and relate them to macro variables. Specifically, the paper decomposes Treasury yields into inflation expectations and maturity-specific interest-rate cycles, which are defined as variation in yields orthogonal to expected inflation. The short-maturity cycle captures the real short-rate dynamics. Jointly with expected inflation, it comprises the expectations hypothesis (EH) term in the yield curve. Controlling for the EH term allows us to extract a measure of risk premium variation from yields. The risk premium factor forecasts excess bond returns in and out of sample and subsumes the commonly used bond return predictor obtained as a linear combination of forward rates.

This publication highlights the importance of macro trends for understanding the movements in yields. It also provides a simple model for estimating long-horizon inflation expectations in real time.