Inflation Bets on the Long Bond
Review of Financial Studies, Volume 30, Issue 3, 1 March 2017
85 Pages Posted: 14 Jul 2014 Last revised: 6 May 2018
Date Written: July 19, 2016
The liquidity premium theory of interest rates predicts that the Treasury yield curve steepens with inflation uncertainty as investors demand larger risk premia to hold long-term bonds. Using the dispersion of inflation forecasts to measure this uncertainty, we find the opposite. Since the prices of long-term bonds move more with inflation than short-term ones, investors also disagree and speculate more about long-maturity payoffs with greater uncertainty. Shorting frictions, measured using Treasury lending fees, then lead long maturities to become over-priced and the yield curve to flatten. We estimate this inflation-betting effect using time variation in inflation disagreement and Treasury supply.
Keywords: Bond Prices, Term Structure of Interest Rates, Shorting Frictions, Lending Fees, Speculation, Disagreement
JEL Classification: G11, G12
Suggested Citation: Suggested Citation