Expectation Formation in the Treasury Bond Market

87 Pages Posted: 21 Nov 2019 Last revised: 8 Jan 2020

See all articles by Zhengyang Xu

Zhengyang Xu

City University of Hong Kong - Department of Economics & Finance

Date Written: November 25, 2019


I document that subjective bond risk premia implied by survey forecasts of future Treasury yields are acyclical at the one-year horizon. This is in stark contrast to large countercyclical variation in objective risk premia fitted from in-sample predictive regressions of future bond excess returns. This difference in risk premia implies a wedge between subjective and objective expectations of future short rates, which I show is predictable by trend and cycle components of macroeconomic forecasts. I show that these empirical findings can be explained with a learning model in which the agent filters latent trend and cycle components of fundamentals in real time, while an econometrician analyzing the data ex-post has full knowledge of the data-generating processes. The model also yields predictions, consistent with the data, on the joint behavior of the unconditional yield curve slope, the cyclicality of short-rate and macroeconomic expectation wedges, and the cyclicality of objective risk premia. My results suggest that equilibrium models of bond risk premia should target acyclical subjective risk premia and expectation formation, rather than ex-post in-sample fitted risk premia from predictive regressions.

Keywords: Bond risk premia, Expectation errors, Macroeconomic expectation formation

JEL Classification: G12, E03

Suggested Citation

Xu, Zhengyang, Expectation Formation in the Treasury Bond Market (November 25, 2019). Available at SSRN: https://ssrn.com/abstract=3483414 or http://dx.doi.org/10.2139/ssrn.3483414

Zhengyang Xu (Contact Author)

City University of Hong Kong - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Hong Kong

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