A Portfolio-Balance Approach to the Nominal Term Structure

Abstract

I examine how the maturity structure of outstanding government liabilities affects the nominal yield curve under a variety of assumptions about investor objectives. In the class of models I consider, equilibria are arbitrage free, expectations are rational, and assets are valued only for their pecuniary returns. Nonetheless, a portfolio-balance mechanism arises through the dependence of the pricing kernel on the return on wealth. This mechanism results in a positive relationship between the duration of bondholders' portfolios and the price of interest-rate risk. Quantitatively, the models suggest that the effects of shifting Treasury supply on yields can be substantial -- for example, the increase in the average maturity of U.S. government debt that occurred between 1976 and 1988 may have raised the ten-year yield by 50 basis points. On the other hand, partly reflecting an attenuation of portfolio-balance e¤ects when interest rates are near zero, the Federal Reserve's asset purchase programs likely had a fairly small impact on the yield curve by removing duration from the market.

Keywords: Yield curve, LSAP, asset purchase, Treasury supply, zero lower bound, quantitative easing, preferred habitat, forward guidance

JEL Classification: C63, E43, E44, E52, E58, G11, G12