Short-Rate Expectations and Unexpected Returns in Treasury Bonds
Review of Financial Studies, Forthcoming
77 Pages Posted: 28 Mar 2013 Last revised: 4 May 2018
Date Written: September 30, 2017
I document large and persistent errors in investors' expectations about the short-term interest rate over the business cycle. The largest errors arise in economic downturns and during Fed easings when investors overestimate future short rates and, thus, underestimate future bond returns. At a one-year horizon, errors about the path of the real rate (as opposed to inflation) account for 80% of short-rate forecast error variance, with more than half of that number attributed to the Fed easing more aggressively than the public expected. Short-rate forecast errors induce ex post predictability of excess returns on Treasury bonds that is not due to time-varying risk premium.
Keywords: short-rate expectations, forecast errors, bond risk premia, real rate, predictability
JEL Classification: G12, G14, G17
Suggested Citation: Suggested Citation