Monetary Policy and Treasury Risk Premia

Abstract

This paper studies the properties of bond risk premia in an economy with recursive preferences, long run risks, and monetary policy. The solution for bond yields is quadratic and monetary policy shocks command a time varying price of risk. An empirical proxy of monetary policy shocks is obtained from the residuals of panel regressions estimated over an extensive survey of Federal funds, gdp and inflation forecasts. The analysis shows that monetary policy shocks predict future bond returns in an economically and significant way: univariate regressions for bond maturities of 2 years reveal that monetary policy shocks account for 16% of the time variation in realized returns. Excluding the last financial crisis from the sample significantly strengthens the results, which we interpret as a consequence of constraints imposed by the zero-bound.

Keywords: monetary policy, FOMC, fixed income, volatility, trade, uncertainty

JEL Classification: D9, E3, E4, G12