Predictability in the Shape of the Term Structure of Interest Rates

Abstract

Evidence of predictability in the time-varying shape of the U.S. term structure of interest rates is demonstrated using a robust recursive modeling approach based on a Bayesian mixture of multifactor models. Variables such as default spread, equity volatility, and short-term and forward rates can be used to predict changes in the slope of the yield curve and (to a lesser extent) changes in its curvature. Systematic trading strategies based on butterfly swaps reveal that this evidence of predictability in the shape of the yield curve is both statistically and economically significant.