Predicting Bond Return Predictability

This paper provides empirical evidence on predictable shifts in the degree of bond return predictability. Bond returns are predictable in high (low) economic activity (uncertainty) states, which suggests that the expectations hypothesis of the term structure holds periodically. These state-dependencies in predictability, established by introducing a new multivariate test for equal conditional predictive ability, can be used in real-time to improve out-of-sample bond risk premia estimates and investors' economic utility through a novel dynamic forecast combination scheme. Dynamically combined forecasts exhibit strong countercyclical behavior and peak during recessions. The empirical findings can be explained within a non-linear term structure model