Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity

Estimating the liquidity differential between inflation-indexed and nominal bond yields, we separately test for time-varying real rate risk premia, inflation risk premia, and liquidity premia in U.S. and U.K. bond markets. We find strong, model independent evidence that real rate risk premia and inflation risk premia contribute to nominal bond excess return predictability to quantitatively similar degrees. The estimated liquidity premium between U.S. inflation-indexed and nominal yields is systematic, ranges from 30 bps in 2005 to over 150 bps during 2008-2009, and contributes to return predictability in inflation-indexed bonds. We find no evidence that bond supply shocks generate return predictability.

Inflation-Indexed Bonds and the Expectations Hypothesis

This paper empirically analyzes the Expectations Hypothesis (EH) in inflation-indexed (or real) bonds and in nominal bonds in the US and in the UK. We strongly reject the EH in inflation-indexed bonds, and also confirm and update the existing evidence rejecting the EH in nominal bonds. This rejection implies that the risk premium on both real and nominal bonds varies predictably over time. We also find strong evidence that the spread between the nominal and the real bond risk premium, or the break-even inflation risk premium, also varies over time. We argue that the time variation in real bond risk premia mostly likely reflects both a changing real interest rate risk premium and a changing liquidity risk premium, and that the variability in the nominal bond risk premia reflects a changing inflation risk premium. We estimate significant time series variability in the magnitude and sign of bond risk premia.

Monetary Policy Drivers of Bond and Equity Risks

The exposure of US Treasury bonds to the stock market has moved considerably over time. While it was slightly positive on average in the period 1960-2011, it was unusually high in the 1980s and negative in the 2000s, a period during which Treasury bonds enabled investors to hedge macroeconomic risks. This paper explores the effects of monetary policy parameters and macroeconomic shocks on nominal bond risks, using a New Keynesian model with habit formation and discrete regime shifts in 1979 and 1997. The increase in bond risks after 1979 is attributed primarily to a shift in monetary policy towards a more anti-inflationary stance, while the more recent decrease in bond risks after 1997 is attributed primarily to an increase in the persistence of monetary policy interacting with continued shocks to the central bank’s inflation target. Endogenous responses of bond risk premia amplify these effects of monetary policy on bond risks.Economic

Inflation and Asset Prices

Do corporate bond spreads reflect fear of debt deflation? Most corporate bonds have fixed nominal face values, so unexpectedly low inflation raises firms' real debt burdens and increases default risk. The first chapter develops a real business cycle model with time-varying inflation risk and optimal, but infrequent, capital structure choice. In this model, more volatile or more procyclical inflation lead to quantitatively important credit spread increases. This is true even with inflation volatility as moderate as that in developed economies since 1970. Intuitively, this result obtains because inflation persistence generates large uncertainty about the price level at long maturities and because firms cannot adjust their capital structure immediately. We find strong empirical support for our model predictions in a panel of six developed economies. Both inflation volatility and the inflation-stock return correlation have varied substantially over time and across countries. They jointly explain as much variation in credit spreads as do equity volatility and the dividend-price ratio. Credit spreads rise by 15 basis points if either inflation volatility or the inflation-stock return correlation increases by one standard deviation. Firms counteract higher debt financing costs by adjusting their capital structure in times of higher inflation uncertainty. The second chapter empirically decomposes excess return predictability in inflation-indexed and nominal government bonds into liquidity, market segmentation, real interest rate risk and inflation risk. This chapter finds evidence for time-varying liquidity premia in Treasury Inflation Protected Securities (TIPS) and for time-varying liquidity premia in TIPS and for time-varying inflation risk premia in nominal bonds. The third chapter develops a pre-test for weak instruments in linear instrumental variable regression that is robust to heteroskedasticity and autocorrelation. Our test statistic is a scaled version of the regular first-stage F statistic. The critical values depend on the long-run variance-covariance matrix of the first stage. We apply our pre-test to the instrumental variable estimation of the Elasticity of Intertemporal Substitution and find that instruments previously considered not to be weak do not exceed our threshold

A robust test for weak instruments in Stata

We introduce a routine, weakivtest, that implements the test for weak instruments by Montiel Olea and Pflueger (2013, Journal of Business and Economic Statistics 31: 358–369). weakivtest allows for errors that are not conditionally homoskedastic and serially uncorrelated. It extends the Stock and Yogo (2005, Testing for weak instruments in linear IV regression. In Identification and Inference for Econometric Models: Essays in Honor of Thomas Rothenberg, ed. D. W. K. Andrews and J. J. Stock, 80–108. [Cambridge University Press]) weak-instrument tests available in ivreg2 and in the ivregress postestimation command estat firststage. weakivtest tests the null hypothesis that instruments are weak or that the estimator’s Nagar (1959, Econometrica 27: 575–595) bias is large relative to a benchmark for both two-stage least-squares estimation and limited-information maximum likelihood with one endogenous regressor. The routine can accommodate Eicker–Huber–White heteroskedasticity robust estimates, Newey and West (1987, Econometrica 55: 703–708) heteroskedasticity- and autocorrelation-consistent estimates, and clustered variance estimates