Nonlinear Dynamics of Conditional Term Premia and Business Cycles

The characterization of term premia movements continues to be a puzzle in finance though the term premia are used for return predictability and studying broader economic activity. We analyze the movements of the first and second conditional moments of term premia in a non-linear non- parametric framework and link movements in these moments to the financial markets and the business cycle. The financial market variables are the short and long yields. The business cycle variables are nondurable consumption growth and inflation. We find that the term premia are negatively related to consumption growth, i.e. the expected term premium is high during recessions, but only the shortest end of the term structure has volatility impacts. Term premia of different maturities react differently to shocks in the yields. We also simulate the effects of shocks over time and find that for the business cycle variables, inflation shocks have transient but similar effects on term premia of different maturities. Consumption shocks on the other hand tend to have greater persistence. These findings have implications for both theories and use of term-structure models