Bond yields respond to policy decisions by the Federal Reserve and vice versa. To learn about these responses, I model a high‐frequency policy rule based on yield curve information and an arbitrage‐free bond market. In continuous time, the Fed's target is a pure jump process. Jump intensities depend on the state of the economy and the meeting calendar of the Federal Open Market Committee. The model has closed‐form solutions for yields as functions of a few state variables. Introducing monetary policy helps to match the whole yield curve, because the target is an observable state variable that pins down its short end and introduces important seasonalities around FOMC meetings. The volatility of yields is "snake shaped," which the model explains with policy inertia. The policy rule crucially depends on the two‐year yield and describes Fed policy better than Taylor rules.

We study time variation in expected excess bond returns. We run regressions of one-year excess returns on initial forward rates. We find that a single factor, a single tent-shaped linear combination of forward rates, predicts excess returns on one-to five-year maturity bonds with R 2 up to 0.44. The return-forecasting factor is countercyclical and forecasts stock returns. An important component of the return-forecasting factor is unrelated to the level, slope, and curvature movements described by most term structure models. We document that measurement errors do not affect our central results.

From a macroeconomic perspective, the shortterm interest rate is a policy instrument under the direct control of the central bank, which adjusts the rate to achieve its economic stabilization goals. From a finance perspective, the short rate is a fundamental building block for yields of other maturities, which are just riskadjusted averages of expected future short rates. Thus, as illustrated by much recent research, a joint macro-finance modeling strategy will provide the most comprehensive understanding of the term structure of interest rates. In this paper, we discuss some salient questions that arise in this research, and we also present a new examination of the relationship between two prominent dynamic, latent factor models in this literature: the Nelson-Siegel and affine no-arbitrage term-structure models. I. Questions about Modeling Yields 1. Why Use Factor Models for Bond Yields?—The first problem faced in term-structure modeling is how to summarize the price information at any point in time for the large number of nominal bonds that are traded. In fact, since only a small number of sources of systematic risk appear to underlie the pricing of the myriad of tradable financial assets, nearly all bond price information can be summarized with just a few constructed variables or factors. Therefore, yield-curve models almost invariably employ a structure that consists of a small set of factors and the associated factor loadings