Market expectations of the short rate and the term structure of interest rates: a new perspective from the classic model

Based on the classic Gaussian dynamic term structure model A_0(3), I rotate the model to a special representation, the so called 'Companion Form Realization', in which the state variables comprises the short rate and its related expectations. This unique feature makes the representation very useful in analyzing the response of the yield curve to the shocks in the short rate and its related expectations, and monitoring market expectations. Using the estimated model, I quantify a variety of yield responses to the changes in these important state variables; and also give an 'unsurprising' pattern in which changes in state variables have little impact on the long end of the yield curve. Two case studies of recent unconventional monetary policies are also included.