This paper extends the benchmark Macro-Finance model by introducing, next to the standard macroeconomic factors, additional liquidity-related and return forecasting factors. Liquidity factors are obtained from a decomposition of the TED spread while the return-forecasting (risk premium)factor is extracted by imposing a single factor structure on the one-period expected excess holding returns. The model is estimated on US data using MCMC techniques. Two findings stand out.
First, the model outperforms significantly most structural and non-structural Macro-Finance yield curve models in terms of cross-sectional .t of the yield curve. Second, we find that financial shocks, either in the form of liquidity or risk premium shocks have a statistically and conomically significant impact on the yield curve. The impact of financial shocks extends throughout the yield curve but is
most pronounced at the high and intermediate frequencies.