Term Structure

Board of Governors of the Federal Reserve System

International Finance Discussion Papers Number 993 January 2010

Term Structure Forecasting Using Macro Factors And Forecast Combination Michiel De Pooter Francesco Ravazzolo Dick van Dijk

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Term Structure Forecasting Using Macro Factors and Forecast Combination∗

Michiel de Pooter†

Federal Reserve Board

Francesco Ravazzolo

Norges Bank

Dick van Dijk

Erasmus University Rotterdam

February 3, 2010

Abstract We examine the importance of incorporating macroeconomic information and, in particular, accounting for model uncertainty when forecasting the term structure of U.S. interest rates. We start off by analyzing and comparing the forecast performance of several individual term structure models. Our results confirm and extend results found in previous literature that adding macroeconomic information, through factors extracted from a large number of individual series, tends to improve interest rate forecasts. We then show, however, that the predictive power of individual models varies over time significantly. Models with macro factors are the more accurate in and around recession periods. Models without macro factors do particularly well in low-volatility subperiods such as the late 1990s. We demonstrate that this problem of model uncertainty can be mitigated by combining individual model forecasts. Combining forecasts leads to encouraging gains in predictability, especially for longer-dated...