Are Economic Fundamentals Unable to Explain Current European Benchmark Yields? Empirical Evidence from a Continuous Time Affine Term Structure Model

The results in this paper show that current European benchmark yields can be explained, with a high degree of accuracy, by using an affine term structure (ATS) model with the following four state variables: (i) the EU unemployment rate, (ii) the EU production price index, (iii) the ECB monetary aggregate M3 index and, (iv) the EU consumer confidence index. In fact, the present calculations accounts for the EONIA rate from Dec 1999 to Jan 2011 remarkably well. Furthermore, German government bonds with maturities ranging from 3 month to 30 years are observed to be reproduced fairly well, too. Additionally, the predictive capability of the ATS model is also analysed. It is found that the parameters connecting bond-yields with state-variables do not change with time so rapidly. As a consequence, the values that bond yields may have in the future can be calculated with an accuracy that solely depends on the precision one may achieve in predicting the state variables. Finally, the results presented in this paper show that current yield curve levels are satisfactorily explained by economic fundamentals, and cast a doubt on press headlines pointing the current yields to speculative effects of market participants acting irrationally