Level and Volatility Shocks to Fiscal Policy: Term Structure Implications
101 Pages Posted: 15 Sep 2016 Last revised: 10 Feb 2019
Date Written: January 27, 2019
Fiscal policy matters for bond risk premia. Empirically, government spending level and volatility generate term structure level and slope movements, and they are significant predictors of future excess bond returns. Government spending level and volatility are also priced factors in the cross-section of bond and stock portfolios. 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 model 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