No-Arbitrage Macroeconomic Determinants of the Yield Curve

We determine which macroeconomic variables other than inflation and real activity drive the yield curve in the framework of the no-arbitrage affine term structure models. We construct a model-based dynamic projection of all the latent factors onto the observable macro factors, which are real activity and inflation. As a result, the factors are decomposed into the macro-part: a linear function of inflation, real activity and their lags, and the truly novel part which is orthogonal to the entire history of the macro variables. We find that the macro-part of a four-factor model can explain 80% of the variation in the short rate and 50% of the slope. Furthermore, we are able to explain the remaining part of the short rate and slope with such measures of monetary shocks as the AAA credit spread and MZM measure of money supply, and public government debt growth as a measure of fiscal shocks. Finally, we decompose the term premia into the contributions of the identified macro sources of risk. Inflation and liquidity risk premia jointly explain 65% to 85%, depending on a bond maturity, of the variation in the term premia. Inflation and fiscal shock contribute to the deviations from the expectation hypothesis the most.