Affine term structure modeling and macroeconomic risks at the zero lower bound

Abstract

We propose the first affine pricing model capturing the joint dynamics of macroeconomic variables and the yield curve while being consistent with the zero lower bound. Our model-implied short-rate distribution has a probability-mass at its lower bound and depends on quadratic combinations of Gaussian macroeconomic and yield-specific factors. With a standard pricing kernel, interest rates and their forecasts are closed-form functions of the macroeconomy. Our empirics investigate the pricing of inflation risks in nominal U.S. rates. We show that the recent crisis triggers substantial short- term deflation fears, so keeping interest rates low is beneficial for the macroeconomy and investors' utility.