Consumption risk and the cross-section of government bond returns

In this paper we provide a consumption-based explanation of risk in nominal US Treasury bond portfolios. We use a consumption-CAPM with Epstein–Zin–Weil recursive preferences. Our model introduces two sources of risk: uncertainty about current consumption (reflected in contemporaneous consumption growth) and uncertainty about prospects of consumption in a long run (reflected in innovations to expectations about future consumption growth). We use a novel approach to estimate pricing factors in our model: we employ a factor-augmented VAR model with common factors, extracted from a large panel of macroeconomic and financial data, as state variables. We find that the important source of risk in US bonds is related to uncertainty in prospects in future consumption and it induces a positive and significant risk premium. We find as well that covariance risk related to innovations in expectations about future consumption growth is greater for long term bond portfolios than for short term bond portfolios, which is consistent with a duration measure of risk and justifies why long term bonds require greater premium than short term bonds. Our model explains well the cross-sectional variation in average excess returns of bonds with different maturities over the period 1975–2011 and compares favorably with competing models.     

Uncovering the US term premium: An alternative route

The estimates of the US term premium crucially depend upon the ex-ante decision on whether the short-term rate is either an I(0) or an I(1) process. In this paper we estimate a fractionally integrated (I(d)) model which simultaneously determines both the order of integration of the short-term rate and the associated term premium. We show that the term premium experienced a sharp increase from essentially zero in mid-2007 to almost 3% in 2009. We also show that unemployment and term premium dynamics exhibit a very significant positive co-movement.     

Predictability of Term Spread for Economic Activity with Liquidity Premium Theory

In this article, we explore the predictive content of the term spread based on the liquidity premium theory. We decompose the contribution of the spread into the effect of expected future changes in short rates and the effect of the term premium. We also examine whether the predictive power of the term spread for real economic activity can be enhanced by such a decomposition. The basic finding is that both the expectations effect and the term premium effect are relevant for predicting economic fluctuations. In particular, we find that the decomposition might lead to a better prediction for the business-cycle turning points than the usual term spread.     

Mortgage timing

We study how the term structure of interest rates relates to mortgage choice at both household and aggregate levels. A simple utility framework of mortgage choice points to the long-term bond risk premium as distinct from the yield spread and the long yield as a theoretical determinant of mortgage choice: when the bond risk premium is high, fixed-rate mortgage payments are high, making adjustable-rate mortgages more attractive. We confirm empirically that the bulk of the time variation in both aggregate and loan-level mortgage choice can be explained by time variation in the bond risk premium, whether bond risk premia are measured using forecasters’ data, a vector autoregressive (VAR) term structure model, or a simple household decision rule based on adaptive expectations. The household decision rule moves in lock-step with mortgage choice, lending credibility to a theory of strategic mortgage timing by households.     

Consumption growth predictability and asset prices

We derive and test a consumption-based intertemporal asset pricing model in which an asset earns a risk premium if it performs poorly when expected future consumption growth deteriorates. The predictability of consumption growth combined with the recursive preference delivers news about future consumption growth an additional risk factor, in addition to news about current consumption growth. We model the consumption growth dynamics using a vector autoregressive (VAR) structure with a set of instrumental variables commonly used for forecasting future economic growth. Our VAR estimation provides strong empirical support for future consumption growth predictability. The cross-sectional test shows that the model explains reasonably well the dispersion in average excess returns of 25 portfolios sorted on size and book-to-market, as well as 25 portfolios sorted on size and long-term return reversal. Growth stocks and long-term winners underperform value stocks and long-term losers, respectively, because growth stocks and long-term winners hedge adverse changes in the future consumption growth opportunities.     

Can Stock Volatility Be Benign? New Measurements and Macroeconomic Implications

We find nonsynchronized movements of two new measures of financial market uncertainty—good and bad volatility—which are based on the maximum and minimum stock prices within a month. Good (bad) volatility is associated with better (worse) expectations about the future economic situation and clearly signals acceleration (deceleration) in economic activity. The VAR results indicate that (i) output, employment, and stock price plummet rapidly in response to a bad volatility shock, while their responses to a good volatility shock are modest, and (ii) bad volatility shocks explain the bulk of economic activity and stock price fluctuations in the medium run.     

Stock market short-termism—an international perspective

This study uses a VAR approach with a time-varying risk premium to see if stock market investors are short-term oriented, placing too much weight on current and near cash flows. Using aggregate stock market data for Australia, Germany, Japan, USA and UK markets (1977–1999), we find the degree of persistent under-valuation of future cash flows is far higher in the UK relative to the other countries in our sample, and is market-wide. Also, over the period, US investors appear to have consistently underestimated long horizon cash flows in current stock market valuations relative to a rational valuation model.     

What determines the stock market's reaction to monetary policy statements?

We find that information communicated through monetary policy statements has important business cycle dependent implications for stock prices. For example, during periods of economic expansion, stocks tend to respond negatively to announcements of higher rates ahead. In recessions, however, we find a strong positive reaction of stocks to seemingly similar signals of future monetary tightening. We provide evidence that the state dependence in the stock market's response is explained by information about the expected equity premium and future corporate cash flows contained in monetary policy statements. We also show state dependence in the average stock returns on days of scheduled FOMC meetings and in the impact of monetary policy statements on stock and bond return volatility.     

Identifying VARS based on high frequency futures data

Using the prices of federal funds futures contracts, we measure the impact of the surprise component of Federal Reserve policy decisions on the expected future trajectory of interest rates. We show how this information can be used to identify the effects of a monetary policy shock in a standard VAR. This alternative approach to identification is quite different, and, we argue, more plausible, than the conventional identifying restrictions. We find that a usual recursive identification of the model is rejected, as is any identification that insists on a monetary policy shock having an exactly zero effect on prices contemporaneously. We nevertheless agree with the conclusion of much of the VAR literature that only a small fraction of the variance of output can be attributed to monetary policy shocks.     

Investor strategies in the green bond market: The influence of liquidity risks,economic factors and clientele effects

The green bond market has dramatically expanded especially in Europe but severe liquidity issues may undermine its rapid development. If few studies have assessed the implied liquidity risks for investors in terms of liquidity premium, none of them have specifically analysed its behavior across bond maturities. To fill this gap, this paper studies the term structure of the liquidity premium of the green bond market.We find that the sizes of short-term and long-term premia are close to those estimated on the German government bond market. We show that those premia are affected by economic factors and by spillover effects between them, which contribute to the U-Shape of the liquidity premium. Finally, we detect a liquidity clientele effect on the ask side impacting the liquidity premium, which implies a maturity segmentation i.e., high-risk (resp. low-risk) investors buy short-term (resp. long-term) green bonds and hold them until maturity.Taken together, our results deliver valuable insights on investors' strategies in the green bond market. Quite importantly, green bond investors prefer to opt for buy and hold strategies because they are compensated for higher liquidity risks along the entire maturity spectrum.     

Three aspects of the Swiss term structure: an empirical survey

The term structure is an important transmitter of, and indicator for, monetary policy. This paper studies the Swiss term structure using monthly data from 1989 to 2005. We study the impact of the new monetary policy strategy that the Swiss National Bank (SNB) adopted at the beginning of 2000 on three aspects of the term structure. First, we test the expectations hypothesis and find it confirmed at the short end of the yield curve. At the long end, time-varying term premia seem present. Second, we ask whether the yield curve contains information regarding future inflation and economic activity. We find that a steepening of the yield curve predicted an increase in economic activity in the short term before the change in policy strategy, but not thereafter. Third, we study the contemporaneous reaction of the term structure to macroeconomic conditions and conclude that the SNB’s commitment to stabilizing inflation may have become more credible after the change in the monetary policy strategy.      

The Cyclical Behavior of Interest Rates

This article investigates the behavior of the term structure of interest rates over the business cycle. In contrast to prior studies that measure the business cycle by the simple growth in aggregate economic activity, we consider the deviation of aggregate economic activity from its potentially stochastic trend. We show that incorporating both an independent trend and cyclical component in consumption improves the efficiency in estimating consumption-based asset pricing models. We also find that the term spread is more informative about future changes in stochastically detrended real gross domestic product (GDP) than future growth rates in real GDP.     

The expectations hypothesis: New hope or illusory support?

Recent studies of the expectations hypothesis of the term structure (EHTS) find evidence in favor of the EHTS using post 1980s US data. This has been attributed to the relative macro stability of this period and greater market efficiency. Using a panel of forecasts for 3-month interest rates for ten countries we test separately for EHTS and rational expectations. Assuming rational expectations holds we find support for the EHTS is illusory due to an off-setting time-varying term premia and non-rational expectations. Previous forecast-based studies suggest biased expectations tend to reinforce the effect of a time varying term premium. This change can be understood in the context of Fama’s (2006) argument that markets tend to underestimate future spot rates during periods of long-run increases and overestimate during declines.     

The fed and the term structure: Addressing simultaneity within a structural VAR model

This paper applies a new identification approach to estimate the contemporaneous relation between the term structure and monetary policy within a VAR framework. To achieve identification, we combine high-frequency Treasury futures and fed funds futures data with the VAR methodology. Results indicate that policy actions have a slope effect in the yield curve. We also find that the Fed responds to Treasury yields and that this response is stronger for the short and intermediate rates and less aggressive for long-yields. All estimated parameters are significant and robust to various model specifications.     

A Markov switching unobserved component analysis of the CDX index term premium

Using a Markov switching unobserved component model we decompose the term premium of the North American CDX index into a permanent and a stationary component. We establish that the inversion of the CDX term premium is induced by sudden changes in the unobserved stationary component, which represents the evolution of the fundamentals underpinning the probability of default in the economy. We find evidence that the monetary policy response from the Fed during the crisis period was effective in reducing the volatility of the term premium. We also show that equity returns make a substantial contribution to the term premium over the entire sample period.     

Inflation ambiguity and the term structure of U.S. Government bonds

Variations in trend inflation are the main driver for variations in the nominal yield curve. According to empirical data, investors observe a set of empirical models that could all have generated the time-series for trend inflation. This set has been large and volatile during the 1970s and early 1980s and small during the 1990s. I show that log utility together with Knightian uncertainty about trend inflation can explain the term premium in U.S. Treasury bonds. The equilibrium has two inflation premiums, an inflation risk premium and a Knightian inflation ambiguity premium.     

Monetary Policy Uncertainty and the Response of the Yield Curve to Policy Shocks

This paper studies the nonlinear response of the term structure of interest rates to monetary policy shocks and presents a new stylized fact. We show that uncertainty about monetary policy changes the way the term structure responds to monetary policy. A policy tightening leads to a significantly smaller increase in long-term bond yields if policy uncertainty is high at the time of the shock. We also look at the decomposition of bond yields into expectations about future policy and the term premium. The weaker response of yields is driven by the fall in term premia, which fall more strongly if uncertainty about policy is high. Conditional on a monetary policy shock, higher uncertainty about monetary policy tends to make securities with longer maturities relatively more attractive to investors. As a consequence, investors demand even lower term premia. These findings are robust to the measurement of monetary policy uncertainty, the definition of the monetary policy shock, and to changing the model specification.     

Taylor rules, McCallum rules and the term structure of interest rates

Recent empirical research shows that a reasonable characterization of federal-funds-rate targeting behavior is that the change in the target rate depends on the maturity structure of interest rates and exhibits little dependence on lagged target rates. See, for example, Cochrane and Piazzesi [2002. The Fed and interest rates—a high-frequency identification. American Economic Review 92, 90-95.]. The result echoes the policy rule used by McCallum [1994a. Monetary policy and the term structure of interest rates. NBER Working Paper No. 4938.] to rationalize the empirical failure of the ‘expectations hypothesis’ applied to the term structure of interest rates. That is, rather than forward rates acting as unbiased predictors of future short rates, the historical evidence suggests that the correlation between forward rates and future short rates is surprisingly low. McCallum showed that a desire by the monetary authority to adjust short rates in response to exogenous shocks to the term premiums imbedded in long rates (i.e. “yield-curve smoothing”), along with a desire for smoothing interest rates across time, can generate term structures that account for the puzzling regression results of Fama and Bliss [1987. The information in long-maturity forward rates. The American Economic Review 77, 680-392.]. McCallum also clearly pointed out that this reduced-form approach to the policy rule, although naturally forward looking, needed to be studied further in the context of other response functions such as the now standard Taylor [1993. Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy 39, 195-214.] Rule. We explore both the robustness of McCallum's result to endogenous models of the term premium and also its connections to the Taylor Rule. We model the term premium endogenously using two different models in the class of affine term-structure models studied in Duffie and Kan [1996. A yield-factor model of interest rates. Mathematical Finance 57, 405-443.]: a stochastic volatility model and a stochastic price-of-risk model. We then solve for equilibrium term structures in environments in which interest rate targeting follows a rule such as the one suggested by McCallum (i.e., the “McCallum Rule”). We demonstrate that McCallum's original result generalizes in a natural way to this broader class of models. To understand the connection to the Taylor Rule, we then consider two structural macroeconomic models which have reduced forms that correspond to the two affine models and provide a macroeconomic interpretation of abstract state variables (as in Ang and Piazzessi [2003. A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables. Journal of Monetary Economics 50, 745-787.]). Moreover, such structural models allow us to interpret the parameters of the term-structure model in terms of the parameters governing preferences, technologies, and policy rules. We show how a monetary policy rule will manifest itself in the equilibrium asset-pricing kernel and, hence, the equilibrium term structure. We then show how this policy can be implemented with an interest-rate targeting rule. This provides us with a set of restrictions under which the Taylor and McCallum Rules are equivalent in the sense if implementing the same monetary policy. We conclude with some numerical examples that explore the quantitative link between these two models of monetary policy.     

Daily monetary policy shocks and new home sales

The conventional notion of a monetary policy shock as a surprise change in the fed funds rate is misspecified. The primary news for market participants is not what the Fed just did, but is instead new information about the Fed's future intentions. Revisions in these anticipations show up instantaneously in long-term mortgage rates. Home sales do not respond until much later. This paper attributes this delay—and hence much of the hump-shaped response of economic activity to monetary policy—to cross-sectional heterogeneity in search times. This framework allows one in principle to measure policy impacts at the daily frequency.     

Time-varying term premium in T-bill futures rate and the expectations hypothesis

This paper examines time-varying term premium in the T-bill futures rate to determine its significance for the expectations hypothesis (EH). Similar to previous studies on the T-bill forward rates, our data reject the joint hypothesis of the EH and the rational expectations hypothesis (RE). Under the assumption of zero rational expectational error, we find a substantial variation of term premium in the futures rate over time. Furthermore, the lower bound of the expected term premium variance is significantly positive when the rational expectational error is allowed to be nonzero. These findings are inconsistent with the EH. In addition, a relatively high ratio of the lower bound of the expected term premium variance to the prediction error variance implies that the poor predictive power of the futures rate should not be attributed mainly to the market's rational expectational errors.