Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds

83 Pages Posted: 17 Feb 2009 Last revised: 4 Sep 2010

See all articles by John Y. Campbell

John Y. Campbell

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Adi Sunderam

Harvard Business School

Luis M. Viceira

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: February 2009

Abstract

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 specifies 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.

Suggested Citation

Campbell, John Y. and Sunderam, Adi and Viceira, Luis M., Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds (February 2009). NBER Working Paper No. w14701. Available at SSRN: https://ssrn.com/abstract=1344683

John Y. Campbell (Contact Author)

Harvard University - Department of Economics ( email )

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Adi Sunderam

Harvard Business School ( email )

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Luis M. Viceira

Harvard Business School - Finance Unit ( email )

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617-496-6592 (Fax)

HOME PAGE: http://www.people.hbs.edu/lviceira

National Bureau of Economic Research (NBER)

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