Monetary Policy Uncertainty and Bond Risk Premium

Abstract

We show that uncertainty of monetary policy (MPU) commands a risk premium in the US Treasury bond market. Using the news based MPU measure in Baker, Bloom, and Davis (2016) to capture monetary policy uncertainty, we find that MPU forecasts significantly and positively future monthly Treasury bond excess returns. This forecastability remains significant controlling for standard bond risk premium predictors based on yield curve and macroeconomic fundamentals. The predictive power of MPU is not driven by uncertainty of economic growth, inflation and general economic condition, and is confirmed in out-of-sample tests.

Keywords: Bond Return Predictability, Monetary Policy Uncertainty, Out-of-sample Forecasting

JEL Classification: C22, C53, G11, G12, G17