Level and Volatility Shocks to Fiscal Policy: Term Structure Implications
107 Pages Posted: 15 Sep 2016 Last revised: 1 Oct 2018
Date Written: November 4, 2017
Fiscal policy matters for bond risk premia. Empirically, government spending level predicts future excess bond returns while controlling for principal components and known predictors. Government spending level and volatility both forecast term structure level and slope movements. Theoretically, level shocks raise inflation (term structure level effect) when marginal utility is high, making nominal bonds a poor consumption hedge, thus generating positive inflation risk premia. Volatility shocks to spending have a strong yield curve slope (steepening) effect, producing positive term premia. Asset pricing tests using simulated data corroborate our empirical evidence. Last, fiscal shocks are amplified at the zero lower bound.
Keywords: Term structure, Bond Risk Premia, Uncertainty, Fiscal Policy
JEL Classification: E62, G12
Suggested Citation: Suggested Citation