Monday, November 30, 2015

Principal component = information equilibrium model?

John Cochrane has an interesting paper/blog post about forecasting interest rates. I'm not sure I've absorbed it all quite yet, but I have a quick take.

The key point Cochrane is making is that the reason adding an inflation term to forecast models of interest rates improves them is really just because inflation has a trend -- a trend that roughly follows the first principal component term (PC1 at the link). Adding a trend (with principal components) allows you to get a really good fit -- and in fact it is this trend that captures most of the forecasting capability of the model. Cochrane says this means there a strong one-factor model of bond yields across all maturity. Basically, one interest rate describes them all pretty well.

This is just a cheesy overlay on the principal component graph, but that first principal component seems to be well described by the information equilibrium model:


5 comments:

  1. Purple = Ten year rate
    Black = IT model fit

    Then the 1st 3 "principal components" (PCs) described here and shown in Figure 2 are:
    Blue = PC1
    Red = PC2
    Yellow = PC3

    Just posting for the benefit of anybody else wondering what those colors were (it took me a minute or two to catch on).

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    1. My quick take might have been a little too quick. Thanks for the legend.

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  2. Jason, has Cochrane ever responded to on of your comments?

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    1. Not that I know of, but it gets though moderation which is a good first step. And for some reason a lot of people click on links in comments on his blog. Comparable to Marginal Revolution, which implies a really high engagement rate on Cochrane's blog assuming his traffic is an order of magnitude less.

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    2. I notice that your latest comment is still his only comment on his latest post. No response yet.

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