Testing the expectations hypothesis with survey forecasts: The impacts of consumer sentiment and the zero lower bound in an I(2) CVAR

• This study uses interest rate forecasts to test the expectations hypothesis of the term structure.
• Using CVARs, the term premium is found to move inversely with consumer sentiment at the 1% level.
• Extension to the I(2) CVAR greatly improves the model fit and precision of the estimates.
• It also demonstrates that a fall in the level of the interest rate temporarily increases the premium.

Monthly interest rate forecasts from nearly 50 major financial institutions are used to examine the expectations hypothesis at the short end of the term structure for the Canadian T-bill market and Libor markets in the US, UK, and Switzerland. Using CVARs, the term premium is found to move inversely with consumer sentiment in all four samples at the 1% level. Extension to the polynomial CVAR also suggests that a fall in the interest rate raises the premium, at least temporarily. This is interpreted as arising from the decreasing upside potential for bond price movements related to the zero lower bound.