Information in (and not in) the Term Structure

Standard approaches to building and estimating dynamic term structure models rely on the assumption that yields can serve as the factors. However, the assumption is neither theoret-ically necessary nor empirically supported. This article documents that almost half of the variation in bond risk premia cannot be detected using the cross-section of yields. Fluc-tuations in this hidden component have strong forecast power for both future short-term interest rates and excess bond returns. They are also negatively correlated with aggregate economic activity, but macroeconomic variables explain only a small fraction of variation in the hidden factor. (JEL G12) This article advocates a significant change in the construction and estimation of multifactor term structure models. In a literature spanning more than two decades, researchers have almost universally assumed that the factors driving term structure dynamics can be represented as functions of yields. The assump-tion plays a critical role in all aspects of estimation. However, I conclude here that this assumption rules out an important class of term structure dynamics. Research methodologies that do not rely on it are needed