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

Abstract

There is wide consensus among financial economists that returns on nominal U.S. Treasury bonds in excess of Treasury bills are predictable at different investment horizons. Predictor variables include forward rates (Fama and Bliss, 1987), the slope of the yield curve (Campbell and Shiller, 1991), and a linear combination of forward rates (Cochrane and Piazzesi, 2005). There is however an ongoing discussion about what drives this predictability. We contribute to this discussion by conducting a joint empirical analysis of the sources of excess bond return predictability in nominal and inflation-indexed bonds in the U.S. and the U.K. Specifically, we provide evidence that both time-varying inflation risk premia and time-varying real interest rate risk premia are quantitatively important in explaining time variation in the expected excess return on nominal bonds. The question whether expected excess returns of inflation-indexed bonds are time-varying is important on its own. It remains relatively unexplored, partly due to the short history of U.S. inflation-indexed bonds (Campbell, Shiller, and Viceira, 2009). We contribute to the emerging research on inflation-indexed bonds by examining and distinguishing among three potential sources of excess return predictability in inflation-indexed bonds: time-varying real interest rate risk, timevarying liquidity risk, and market segmentation. Our work differs from recent work on inflationindexed bond return predictability by Campbell, Sunderam, and Viceira (2013) and Pflueger and Viceira (2011) in that it finds and corrects for an economically significant liquidity risk premium, which otherwise would likely distort estimates of real rate and inflation risk premia. Novel and unique to our work is the finding that a liquidity component in breakeven inflation, or the spread between nominal and inflation-indexed bond yields of similar maturity, predicts the return differential between nominal and inflation-indexed bonds due to liquidity. The estimated U.S. return differential due to liquidity exhibits a significantly positive stock market CAPM beta, suggesting that U.S. TIPS investors bear systematic liquidity risk and should be compensated in terms of a positive return premium. While the return differential due to liquidity is not directly 1 tradable, this result is relevant to investors who may differ in terms of their exposure to liquidity crises. Research in financial economics has proposed several theories to explain predictability in nominal excess bond returns. One hypothesis is that excess return predictability results from time variation in the aggregate price of risk. Building on the habit preferences model of Campbell and Cochrane (1999), Wachter (2006) shows that a model with time-varying real interest rates can generate nominal bond excess return predictability. Second, excess return predictability could result from time variation in expected aggregate consumption growth or its volatility. The long-run consumption risk model of Bansal and Yaron (2004) and Bansal, Kik...

The Missing Piece of the Puzzle: Liquidity Premiums in Inflation-Indexed Markets

“…In line with previous literature, we find that nominal bonds are more liquid than other securities -as in Krishnamurthy (2002), Longstaff (2004) or Pflueger and Viceira (2015), among many others.…”

“…First, unlike Pflueger and Viceira (2015) In this section we explain our empirical strategy to examine the effects of liquidity and liquidity risk on prices in the three market segments. We base our empirical identification strategy on previous empirical findings: Amihud and Mendelson (1986) and Amihud (2002) show that average liquidity is priced in stock markets, both in the cross-section of stocks, as well as over time.…”

“…This approach is similar to Pflueger and Viceira (2015), where they also look at yields to identify a liquidity premium in TIPS prices.…”

“…So far, only a handful of studies investigated the breakeven rate, or its relationship with inflation swaps (Campbell et al, 2009;Gürkaynak et al, 2010;Christensen and Gillan, 2011;Pflueger and Viceira, 2015;Fleckenstein et al, 2014) hedging demands, determines the sign of the liquidity premium for markets that are in zero net supply (such as derivative markets). Since these factors are unobservable, especially at the aggregate level, we cannot predict the expected sign of liquidity premiums.…”

Disinflation and the Phillips Curve: Israel 1986-2015

“…We propose to use inflationary expectations derived from financial markets. It is known from the literature that those estimates may not be a pure measure of expectations due to a risk premium and liquidity issues, (see e.g., Pflueger andViceira, 2011). Melnick (2016) estimates an inflation risk bias of 21 basis points for Israel.…”