Forecasting and trading monetary policy effects on the riskless yield curve with regime switching Nelson-Siegel models

We use 1982-2014 data on the US riskless yield curve to show that regime switching dynamics in Nelson-Siegel factor models extended to encompass variables that summarize the state of monetary policy lead to superior predictive accuracy. Such spread in forecasting power turns out to be statistically significant even controlling for parameter uncertainty and sample variation. Exploiting regimes, we obtain evidence that the increase in predictive accuracy is stronger during the Great Financial Crisis, when monetary policy underwent a significant, sudden shift. Although more caution applies in comparisons to a naive random walk benchmark over a few sub-samples and when transaction costs are accounted for, we report that the increase in predictive power owed to the combination of regimes and of variables that capture the stance of unconventional monetary policies is tradeable. We devise and test butterfly strategies that exploit the forecasts from the models and obtain evidence of risk-adjusted profits both per se and in comparisons to simpler models. (C) 2019 Elsevier B.V. All rights reserved.