Monetary policy surprises and international bond markets

We examine the impact and spillover effects of monetary policy surprises on international bond returns. Within the framework of Campbell and Ammer (1993), we decompose international bond returns into news regarding future returns, real interest rates and future inflation for Germany, the U.K. and the U.S. We examine how excess bond returns in these three countries are affected by surprise changes in monetary policy in each country. Our measure of the unanticipated element of monetary policy is based on futures markets rather than the more traditional vector autoregression. Our results indicate that excess bond returns primarily react to domestic as compared to foreign monetary policy surprises. We also find there is a strong divergence between the effects of domestic monetary policy on excess bond returns in Germany relative to the U.K. A surprise monetary tightening in Germany (U.K.) leads to a rise (fall) in the excess holding period return. We trace this effect to news about lower (higher) inflation expectations and could be potentially rationalized by differences in the credibility of the monetary policy authority in each country.