Swedroe: ‘Cycle Factor’ Can Predict Returns

October 28, 2015

Anna Cieslak and Pavol Povala—authors of the paper “Expected Returns in Treasury Bonds,” which was published in the September 2015 issue of The Review of Financial Studies—examined the time variation in the risk premium that investors require for holding Treasury bonds.

While most of the authors’ analysis relies on data starting in 1971 (when data for bond maturities 10 years and longer became available), they also reproduced their main conclusions over the longer sample period from 1952 through 2011 (using maturities of one through five years).


Cieslak and Povala decomposed the nominal yield curve into the risk premium component and the expectations hypothesis (EH) term, which is the average expected short-term interest rate that investors expect to prevail during the life of a bond.

Specifically, they decomposed Treasury yields into inflation expectations and maturity-specific interest-rate cycles, defined as variation in yields unrelated to expected inflation. The economic basis for this division is the premise that the short-term nominal interest rate is (to a very good approximation) the sum of expected inflation and the real short rate. Thus, Cieslak and Povala have three variables with a direct link to economic quantities: expected inflation, the real rate and the risk premium.

They state: “The short-maturity cycle captures the dynamics of the real short rate at the business cycle frequency. Jointly with expected inflation, it comprises the expectations hypothesis (EH) term in the yield curve.”


By controlling for the EH term, the authors were able to extract a measure of the Treasury risk premium from the yield. Their cycle factor is a proxy for the time-varying risk premium in Treasurys. They found that the cycle factor:

  • Is uncorrelated with short-rate expectations
  • Predicts returns on Treasury bonds across the entire maturity spectrum
  • Is the least persistent source of variation in the yield curve, implying that the risk premia in Treasury bonds vary at a frequency greater than the business cycle
  • Is able to predict bond excess returns

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