Forecasting U.K. Yield Curve Dynamics Using Macroeconomic and Asset Pricing Factors: A No-Arbitrage Approach

Abstract

We propose a no-arbitrage affine Gaussian model that links term structure dynamics to the evolution of asset pricing measures along with conventional macroeconomic and latent factors. In contrast to generic factors in FAVAR-type models, our economic factors exploit concept-specific rich data. For the U.K. economy, we find that medium and long-term yields respond more to shocks in asset pricing than real activity. The out-of-sample predictive analysis reveals that the proposed model outperforms traditional no-arbitrage affine Gaussian approaches with conventional macroeconomic and latent factors during the 2007-2010 crisis and post-crisis periods; the contribution of asset pricing measures to forecast accuracy is most pronounced at intermediate and long forecasting horizons. However, models with concept-specific factors only outperform models with generic FAVAR-type factors in the crisis and post-crisis periods, indicating that investors pay closer attention to specific sources of economic risks during periods of heightened economic uncertainty.