Forecasting bond returns in a macro model

We construct predicting factors based on the predictive errors of bond yields and macro variables implied by a linearized dynamic stochastic general equilibrium (DSGE) model to study the predictability of excess bond returns. Our predictors consist of two pieces of information. The predictive errors on bond yields capture the time-varying term premiums missing from the linearized DSGE model, and the predictive errors on macro variables reflect the macro risks that are un-spanned by the yield curve. Predictive regressions of one-year excess bond returns indicate that our predictors outperform the CP factor in Cochrane and Piazzesi (2005). We further relate the bond risk premiums to the inflation target. We find that bond risk premiums vary over time with the inflation target, and are earned as compensation for exposure to innovations of the inflation target. Finally, we show that the predictive errors of bond yields implied by a second-order approximation of the DSGE model still have considerable predictive power on excess returns.