Regime shifts, risk premiums in the term structure, and the business cycle

Recent evidence indicates that using multiple forward rates sharply predicts future excess returns on U.S. Treasury Bonds, with the R-2's being around 30%. The projection coefficients in these regressions exhibit a distinct pattern that relates to the maturity of the forward Fate. These dimensions of the data, in conjunction with the transition dynamics of bond yields, offer a serious challenge to term structure models. In this article we show that a regime-shifting term structure model can empirically account for these challenging data features. Alternative models, such as affine specification, fail to account for these important features. We find that regimes in the model are intimately related to bond risk premia and real business cycles.