Macro Factors in UK Excess Bond Returns: Principal Components and Factor-Model Approach

Erdemlioglu, Deniz (2009): Macro Factors in UK Excess Bond Returns: Principal Components and Factor-Model Approach.

Abstract

We use factor augmented predictive regressions to investigate the relationship between excess bond returns and the macro economy. Our application is for the case of United Kingdom. The dimension of the large data set with 127 variables is reduced by the method of principal components and the Onatski (2009) procedure is used to determine the number factors. Our data covers the period 1983:09 - 2006:10. We find that variation in the one year ahead excess returns on 2 to 5-year UK government bonds can be modeled by macroeconomic fundamentals with R-square values varying from 34 percent to 44 percent. Specifically, three macro factors "unemployment" factor, "inflation" factor and "stock market" factor have significant predictive power in explaining the variation in the excess bond returns. Our results provide new evidence against the expectations hypothesis for the case of UK. We contribute to the literature by analyzing the direct link between macroeconomic variables and excess bond returns for a European market rather than the US. Unpredictability of excess bond returns is not the case in the UK either.

• Item Type: MPRA Paper
• Language: English
• Keywords: Principal Components Analysis (PCA); Expectations Hypothesis; Excess Bond Returns; Factor Models.
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; E - Macroeconomics and Monetary Economics > E0 - General > E00 - General; G - Financial Economics > G1 - General Financial Markets > G10 - General; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates

References

Anderson, N., Sleath, J. (2001). "New Estimates of the UK Real and Nominal Yield Curves", Bank of England Working Paper, (2001), pp. 1-41.

Ang, A., M. Piazzesi (2003). "A No-Arbitrage Vector Autoregression of Term Structure Dynamics With Macroeconomic and Latent Variables", Journal of Monetary Economics 50, (2003), pp. 745-787.

Artis, M., A. Banerjee and M. Marcellino (2005). "Factor Forecasts for the U.K.", Journal of Forecasting 24, (2005), pp. 279-298.

Bai, J., Ng, S. (2002). "Determining the Number of Factors in Approximate Factor Models", Econometrica 70, (2002), pp. 191-221.

Bernanke, B. S., J. Boivin, (2003). \Monetary Policy in a Data-Rich Environment", Journal of Monetary Economics 50 (3), (2003), pp. 525-546.

Bernanke, B. S., J. Boivin, and P. Eliasz (2003). "Measuring the Eects of Monetary Policy: A Factor-Augmented Vector Autoregressive (FAVAR) Approach", Working Paper, (2003), pp. 1-48.

Boivin, J., and M. Giannoni (2005). "DSGE Models in a Data-Rich Environment", Unpublished paper, Columbia University.

Breitung, J., Eickmeier, S. (2005). "Dynamic Factor Models", Deutsche Bundesbank Discussion Paper No: 38/2005, (2005), pp. 1-40.

Brandt, M. W., K. Q. Wang (2003). "Time Varying Risk Aversion and Unexpected Inflation", Journal of Monetary Economics 50, (2003), pp. 1450-1498.

Brillinger, D. R. (1981). "Time Series Data Analysis and Theory", Holt, Rinehart and Winston, (1981), New York.

Campbell, J. Y., J. H. Cochrane (1999). "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behaviour", Journal of Political Economy 107, (1999), pp. 205-251.

Campbell, J. Y., R. J. Shiller (1991). "Yield Spreads and Interest Rates: A Bird's Eye View", Review of Economic Studies 58, (1991), pp. 495-514.

Chamberlain, G. and Rothschild, M. (1983). "Arbitrage, Factor Structure and Mean-Variance Analysis in Large Asset Markets", Econometrica 51, pp. 1305-1324.

Cochrane, J. H. (2005). "Asset Pricing", Revised Edition. Princeton University Press Princeton, NJ, (2005).

Cochrane, J. H., and M. Piazzesi (2005). "Bond Risk Premia", The American Economic Review, 95(1), (2005), pp. 138-160.

Dai, Q., K. Singleton (2002). "Expectation Puzzles, Time-Varying Risk Premia, and Affine Models of the Term Structure, Journal of Financial Economics 63, (2002), pp. 415-441.

Duffie, G. R. (2002). "Term Premia and Interest Rate Forecasts in Affine Models", Journal of Finance 57, (2002), pp. 405-443.

Duffie, G. (2008). "Information in (and not in) the Term Structure", Unpublished paper, Haas School of Business, University of California Berkeley, (2008).

Fama, E., R. Bliss (1987). "The Information in Long-Maturity Forward Rates", American Economic Review 77, (1987), pp. 680-692.

Favero, C., Marcellino, M., Neglia, F. (2005). "Principal Components at Work: The Empirical Analysis of Monetary Policy with Large Datasets", Journal of Applied Econometrics 20, (2005), pp. 603-620.

Forni, M., Hallin, M., Lippi, F., Reichlin L. (2000). "The Generalized Dynamic Factor Model: Identication and Estimation", Review of Economics and Statistics 82, (2001), pp. 540-554.

Forni, M., Hallin, M., Lippi, F., Reichlin L. (2003). "Do Financial Variables Help Forecasting Inflation and Real Activity in the Euro Area", Journal of Monetary Economics 50, (2003), pp. 1243-1255.

Forni, M., Hallin, M., Lippi, F., Reichlin L. (2004). "The Generalized Dynamic Factor Model: Consistency and Convergence Rates", Journal of Econometrics 119, (2004), pp. 231-255.

Forni, M., Hallin, M., Lippi, F., Reichlin L. (2005). "The Generalized Dynamic Factor Model: One-Side Estimation and Forecasting", Consistency and Convergence Rates", Journal of American Statistical Association 100, (2005), pp. 830-840.

Geweke, J. (1977). "The Dynamic Factor Analysis of Economic Time Series", ch. 19 in Aigner, D.J. and A.S. Goldberger (eds.), (1977), Latent variables in socioeconomic models, Amsterdam: North Holland.

Giannone, D., L. Reichlin, and L. Sala (2002). "Tracking Greenspan: Systematic and Unsystematic Monetary Policy Revisited", CEPR Working Paper No. 3550, (2002).

Greenwood, R., Vayanos, D. (2008). "Bond Supply and Excess Bond Returns", AFA 2009 San Francisco Meeting Paper, (February 2008), pp. 1-49.

Gurkaynak, R., Sack, B., Wright, J. H. (2007). "The U.S. Treasury Yield Curve:1961 to the Present", Journal of Monetary Economics 54, (2007), pp. 2291-2304.

Hagan, P. S., West, G. (2006). "Interpolation Methods for Curve Construction", Journal of Applied Mathematical Finance Vol. 13 No. 2, (June 2006), pp. 89-129.

Johnson, R. A., Wichern, D. W. (2007). "Applied Multivariate Statistical Analysis", Asset Pricing", Sixth Edition, Pearson Education, Inc., NJ, (2007).

Kim, H., Moon, J. (2005). "Do Macroeconomic Variables Forecast Bond Returns?", Department of Economics, SUNY at Bualo Working Paper, (2005), pp. 1-36.

Kozicki, S., and P. Tinsley (2005). "Term Structure Transmission of Monetary Policy", Federal Reserve Bank of Kansas city Working Paper 05-06, (2005).

Lanne, M. (1999). "Testing the Expectations Hypothesis of the Term Structure of Interest Rates in the Presence of a Potential Regime Shift", Bank of England Discussion Paper 20/99,(1999), pp. 1-19.

Lekkos, I., Milas, C. (2004). "Time-Varying Excess Returns on UK Government Bonds: A Non-Linear Approach", Journal of Banking and Finance 28, (2004), pp. 45-52.

Litterman, Robert, and Jose Scheinkman (1991). "Common Factors Aecting Bond Returns, Journal of Fixed Income 1, (1991), pp. 54-61.

Ludvigson, S. C. and S. Ng (2005): "Macro Factors in Bond Risk Premia", forthcoming in the Review of Financial Studies.

Ludvigson, S. C., and S. Ng (2006). "The Empirical Risk-Return Relation: A Factor Analysis Approach", Journal of Financial Economics, (2006), forthcoming.

Onatski, A. (2009). "Determining the Number of Factors from Empirical Distribution of Eigenvalues", Columbia University Working Paper, (2006), pp. 1-31.

Piazzesi, M., E. Swanson (2004). "Futures Prices as Risk-Adjusted Forecasts of Monetary Policy", NBER Working Paper No. 10547, (2004).

Quah, D., Sargent, T. J. (1992). "A Dynamic Index Model for Large Cross Sections", Federal Reserve Bank of Minneapolis Discussion Paper 77, (1992), pp. 1-32.

Reijer, Ard H. J. (2005). "Forecasting Dutch GDP using Large Scale Factor Models", DNB Working Paper No.28, (February 2005), pp. 1-37.

Steeley, J. M. (2004). "Estimating Time-Varying Risk Premia in UK Long-Term Government Bonds", Journal of Applied Financial Economics, (2004), pp. 367-373.

Stock, J. H., Watson, M. W. (1998). "Diffusion Indexes", NBER Working Paper 6702, (August 1998), pp. 1-67.

Stock, J. H., Watson, M. W. (1999). "Forecasting Infation", Journal of Monetary Economics 44, (1999), pp. 293-335.

Stock, J. H., Watson, M. W. (2002a). "Macroeconomic Forecasting Using Diffusion Indexes", Journal of Business and Economic Studies 20, (2002a), pp. 147-162.

Stock, J. H., Watson, M. W. (2002b). "Forecasting Using Principal Components form Large Number of Predictors", Journal of American Statistical Association 97, (2002b), pp. 1167-1179.

Stock, J. H., Watson, M. W. (2003). "Forecasting Output and Inflation: The Role of Asset Prices", Journal of Economic Literature 41, (2003), pp. 788-829.

Stock, J. H., Watson, M. W. (2004). "Forecasting With Many Predictors", Unpublished Paper, (2004), Princeton University.

Stock, J. H., Watson, M. W. (2005). "Implications of Dynamic Factor Models for VAR Analysis", NBER Working Paper 11467, (2005), pp. 1-67.

Thornton, D. L. (2005). "Predictions of Short-Term Rates and Expectations Hypothesis of the Term Structure of Interest Rates", Federal Reserve Bank of St. Louis Working Paper 2004-010A, (2005), pp. 1-30.

Wachter, J. (2006). "A Consumption Based Model of the Term Structure of Interest Rates",Journal of Financial Economics 79, (2006), pp. 365-399.

Wright, J. H., Faust, J. (2008). "Efficient Prediction of Excess Returns", NBER Working Paper 14269, (2008), pp. 1-50.