Why Does the Cieslak–Povala Model Predict Treasury Returns? A Reinterpretation

Abstract

This article presents a simple reformulation of the restricted Cieslak and Povala return-predicting factor, which retains by construction exactly the same (impressive) explanatory power as the original but affords an alternative and attractive interpretation. What determines the future returns, the new formulation shows, is a function of the distance of the yield-curve level and the slope not from a fixed reference level, but from a conditional one, determined by a function of the long-term inflation. The decomposition also allows a clear attribution of the predictive power of the Cieslak and Povala factor between the conditional level and slope deviations. The authors present new empirical evidence to show that, consistent with the interpretation they present, inflation surprises are powerful out-of-sample predictors of Treasury excess returns.