Level and Volatility Shocks to Fiscal Policy: Term Structure Implications

101 Pages Posted: 15 Sep 2016 Last revised: 10 Feb 2019

See all articles by Lorenzo Bretscher

Lorenzo Bretscher

London Business School - Department of Finance; affiliation not provided to SSRN

Alex Hsu

Georgia Institute of Technology - Scheller College of Business

Andrea Tamoni

London School of Economics & Political Science (LSE)

Date Written: January 27, 2019

Abstract

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

Bretscher, Lorenzo and Hsu, Alex and Tamoni, Andrea, Level and Volatility Shocks to Fiscal Policy: Term Structure Implications (January 27, 2019). Available at SSRN: https://ssrn.com/abstract=2838667 or http://dx.doi.org/10.2139/ssrn.2838667

Lorenzo Bretscher

London Business School - Department of Finance ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

affiliation not provided to SSRN

Alex Hsu

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States
4043851123 (Phone)

Andrea Tamoni (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
02079557303 (Phone)

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