Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds
John Y. Campbell
Harvard University - Department of Economics; National Bureau of Economic Research (NBER)
Harvard Business School
Luis M. Viceira
Harvard Business School - Finance Unit; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
January 15, 2013
AFA 2009 San Francisco Meetings Paper
Harvard Business School Finance Working Paper No. 09-088
The covariance between US Treasury bond returns and stock returns has moved considerably over time. While it was slightly positive on average in the period 1953-2009, it was unusually high in the early 1980’s and negative in the 2000’s, particularly in the downturns of 2000-02 and 2007-09. This paper species and estimates a model in which the nominal term structure of interest rates is driven by four state variables: the real interest rate, temporary and permanent components of expected inflation, and the “nominal-real covariance” of inflation and the real interest rate with the real economy. The last of these state variables enables the model to fit the changing covariance of bond and stock returns. Log bond yields and term premia are quadratic in these state variables, with term premia determined by the nominal-real covariance. The concavity of the yield curve ― the level of intermediate-term bond yields, relative to the average of short- and long-term bond yields ― is a good proxy for the level of term premia. The nominal-real covariance has declined since the early 1980’s, driving down term premia.
Number of Pages in PDF File: 44
Keywords: Term structure of interest rates, inflation risk, time varying expected returns, bond return predictability, expectations hypothesis, macro asset pricing
JEL Classification: G12working papers series
Date posted: March 20, 2008 ; Last revised: January 15, 2013
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