Decomposing real and nominal yield curves

Abstract

We present an affine term structure model for the joint pricing of real and nominal bond yields that explicitly accommodates liquidity risk premia. We estimate the model using a new, computationally efficient procedure that is based on return regressions. The model allows us to address a number of salient questions about the transmission of monetary policy. We show that variations in U.S. nominal term premia are primarily driven by variations in real term premia rather than inflation and liquidity risk premia. Nonetheless, adjusting breakevens for inflation and liquidity risk substantially improves forecasts of inflation. Our estimates imply that the Federal Reserve's large-scale asset purchases lowered Treasury yields primarily by reducing real term premia. Real term premia also account for the positive response of long-term real forward rates to surprise changes in the federal funds target. Applying our model to U.K. data, we find that the inflation risk premium dropped sharply when the Bank of England formally adopted an inflation target.

The Coming US Interest Rate Tightening Cycle: Smooth Sailing or Stormy Waters?

“…However, new data, or unanticipated changes in Fed communication, could shift expectations. For instance, signs of accelerating wage growth, amid sluggish productivity and a continued decline in labor force participation, may lead market participants to anticipate a faster normalization of policy rates in the short term and to request higher compensation for inflation risks over the medium-term (Abrahams et al 2015).…”

“…The term premium is the extra return required by investors to hold a longer-term bond instead of reinvesting in successive short-term securities, and is positive under normal circumstances. The term premium generally reflects compensation for perceived macroeconomic and financial risks, which could increase, for instance, when the level of disagreement about future inflation among forecasters rises or when implied volatility in U.S. Treasury markets increases (Abrahams et al 2015). Previous monetary policy surprises and the Fed's large-scale asset purchases have been important drivers of U.S. term premia in recent years.…”

“…The effect would unwind after two years, with capital flows in percent of GDP returning close to pre-shock levels. 18 Higher U.S. term premia and a steepening yield curve are often associated with larger financial market volatility and greater risk aversion (Abrahams et al 2015;Adrian, Crump, and Moench 2013b;Borio and Zhu 2012;Adrian and Shin 2011;Dell'Ariccia, Laeven, and Suárez 2013). Greater risk aversion and volatility, in turn, reduce capital flows to EMEs further (Fratzscher 2012;Forbes and Warnock 2012;Bruno and Shin 2015;Lo Duca 2012;Ahmed and Zlate 2013;Bluedorn et al 2013;Rey 2013).…”

" A New Normal for Interest Rates? Evidence from Inflation-Indexed Debt"

“…More generally, the use of interpolated yield curves in term structure analysis can introduce arbitrary and unnecessary measurement error. 7 A second difference is that past TIPS analysis has jointly modeled both the real and nominal yield curves, e.g., Christensen et al (2010), D'Amico et al (2014, and Abrahams et al (2016). Such joint specifications can also be used to estimate the steady-state real rate-though this earlier work has emphasized only the measurement of inflation expectations and risk.…”

The Term Structure and Inflation Uncertainty

“…Term structure models estimated using data prior to the last …nancial crisis (e.g., Ang, Bekaert, and Wei, 2008;Buraschi and Jiltsov, 2005;and Chernov and Mueller, 2012) report estimates of the IRP that are larger in magnitude and mainly positive. In contrast, models focusing on more recent data (e.g., Abrahams et al, 2013;Grishchenko and Huang, 2013;and Fleckenstein, Longsta¤, and Lustig, 2014), deliver values of the IRP that are smaller in magnitude and often negative, especially at shorter maturities.…”