Macro factors and bond excess returns

There are a significant number of macro factors or announcements that can be used to predict the direction of bond excess returns, yet all signals are not created equally. One of the jobs of good researcher is to focus on what has predictive power and discard or place minimal weight on those pieces of information that have less value. 

The bond markets are the bread and butter of global macro investor and there are real and inflation factors that can add forecasting power for futures excess return beyond what can be found in forward rates. (See "Macro Factor in Bond Risk Premia" by Ludvigson and Ng.) The countercyclical behavior of risk premia is driven by these macro factors. Investors are compensated for risk associated with the business and liquidity (inflation) cycles. 

The Fama-Bliss framework showed that excess bond return can be driven by the spread between forward rates and one year yield. The shape of the yield curve is a key driven for return forecasting and can explain about 1/3rd of the next year's return variation in the 2-5-year maturity range.  When macro variables are added to a forward rate factor model (Cochrane-Piazzesi), a model that explain about 44% of next year's excess bond returns. 

The macro inputs are associated with a real factor combination to cover output and employment information and an inflation factor associated with aggregate price levels. Investors need to be compensated from real and inflationary risks. Using 132 monthly economic series based on data from Stock and Watson, the authors find significant factor loadings using principal component analysis (PCA) around real output, inflation, and financial variables. This is done through bundling economic data around a latent factor model. 

The research found that the first component is associated with real economic data like output, employment, orders and housing, and financial data. The second component is associated with financial information like credit spreads while the third and fourth factors are associated with inflation. The eight factor is associated with stock market movements. 

The importance in this work for macro investors is that there is value in macro information that can explain excess returns and bond premia beyond a set of forward rates. Forward prices do not imbed all information about future bond returns.