Regime-Switching Macro Risks in the Term Structure of Interest Rates

A key question to estimate and understand term premium (TP) movements is to identify which macro variables affect TP and whether their effects are time-variant. To address these questions, we propose a new macro-finance arbitrage-free Nelson-Siegel model with regime shifts. In the model, two observable macro factors (i.e., real activity and inflation expectation) widely used in previous studies are considered, and each factor is allowed to have a regime-switching effect on the market price of risks. Further, we estimate the proposed model using a Bayesian MCMC method, and compare it with the resulting restricted models in terms of marginal likelihood. This empirical study using the U.S. yield curve and macroeconomic data reveals that the real activity variable has an unspanned risk and its influences on TPs substantially differ across regimes, where the estimated regimes coincide with the NBER business cycles. In other words, the unspanned real activity risk is more pronounced during expansions than recessions