The Term Structure, Latent Factors and Macroeconomic Data : A Local Linear Level Model

This paper applies a local linear level model to European yields using the state space methodology to structural equation models in order to obtain an unobserved state vector containing the level, slope and seasonal component of the yields. In addition, this has been performed by differentiating money markets from capital markets' yields. Also an affine term structure model has been calibrated using the estimated level, slope and seasonality from the local linear level model. It is shown that both, the local level model as well as the no-arbitrage approach, perform quite well in replicating the yields. The model also shows that there is strong evidence of macroeconomic effects influencing the level, the slope and the seasonal components common to a set of yields (the yield curve). However, this paper shows that there is weak evidence of yields influencing European macroeconomic variables. This could be interpreted as the central bank and markets responding to macroeconomic releases, which is observed in yield movements, but there is weak evidence of yield innovations influencing the macroeconomy