Expected Inflation and Other Determinants of Treasury Yields

Abstract

Shocks to nominal bond yields consist of news about expected future inflation, expected future real short rates, and expected excess returns-all over the bond's life. I estimate the magnitude of the first component for short-and long-maturity Treasury bonds. At a quarterly frequency, variances of news about expected inflation account for between 10% to 20% of variances of yield shocks. Standard dynamic models with long-run risk imply variance ratios close to 1. Habit formation models fare somewhat better. The magnitudes of shocks to real rates and expected excess returns cannot be determined reliably.

Treasuries variance decomposition and the impact of monetary policy

“…They are in contrast, however, to Duffee (2018) who identifies inflation news using survey data and finds that the variance of news about expected inflation explain only between 10% and 20% of the variance of shocks to nominal Treasury yields.…”

“…In the C/A framework, inflation enters the model indirectly as part of the construction of the ex post real interest rate, and inflation news are identified using yields' data-see Section 2.2 for more details. In an earlier working paper version, Duffee (2014) acknowledges that the nonvolatile nature of survey-based inflation expectations is crucial in generating a weaker role for inflation in the variance decomposition: "Although expectations of future inflation are highly persistent, they fluctuate little over time …. Stickiness in survey-based forecasts implies that they may differ from the inflation expectations of investors, as built in bond prices and yields, because the latter are more likely to be frequently updated.…”

“…The differences between the results of studies that use C/A's approach and Duffee (2018) are likely to be driven by different modelling approaches and assumptions regarding the identification of inflation news. In the C/A framework, inflation enters the model indirectly as part of the construction of the ex post real interest rate, and inflation news are identified using yields' data-see Section 2.2 for more details.…”

“…Stickiness in survey-based forecasts implies that they may differ from the inflation expectations of investors, as built in bond prices and yields, because the latter are more likely to be frequently updated. In an earlier working paper version, Duffee (2014) acknowledges that the nonvolatile nature of survey-based inflation expectations is crucial in generating a weaker role for inflation in the variance decomposition: "Although expectations of future inflation are highly persistent, they fluctuate little over time …. Thus mechanically, innovations to expected short-term real rates and term premia are the primary drivers of yield shocks" (p. 2).…”

Consumption, asset wealth, equity premium, term spread, and flight to quality

“…It also seems to corroborate the evidence suggesting that developments in the term spread are associated with variation in inflation, and investors use sovereign bonds to smooth or hedge against unfavorable inflation fluctuations (Lee, ). In this context, Kopp and Williams () show that the term premium is sensitive to changes in inflation, and Duffee () notes that the variance of news about expected inflation accounts for a reasonable fraction of the variation of the variances of nominal bond yield shocks.…”