Under- and Overreaction in Yield Curve Expectations

96 Pages Posted: 5 Dec 2019 Last revised: 6 Oct 2021

See all articles by Chen Wang

Chen Wang

University of Notre Dame - Mendoza College of Business

Date Written: October 5, 2021

Abstract

I document a robust pattern in how Treasury market participants' yield curve expectations respond to new information: forecasts for short-term rates underreact to news while forecasts for long-term rates overreact. I propose a new explanation of this based on ``autocorrelation averaging,'' whereby, due to limited processing capacity, forecasters' estimate of the autocorrelation of a given process is biased toward the average autocorrelation of all related processes. Consistent with this view, forecasters overestimate the autocorrelation of the less persistent term-premium component of interest rates and underestimate the autocorrelation of the more persistent short-rate component; a calibrated model quantitatively matches the documented pattern of misreaction. Moreover, banks' allocations to Treasuries vary positively with their expectations of bond returns and misreaction proxies can strongly predict future short- and long-term bond returns, respectively.

Keywords: expectations formation, yield curve, autocorrelation averaging, bond return predictability

JEL Classification: D83, E43, G12

Suggested Citation

Wang, Chen, Under- and Overreaction in Yield Curve Expectations (October 5, 2021). Available at SSRN: https://ssrn.com/abstract=3487602 or http://dx.doi.org/10.2139/ssrn.3487602

Chen Wang (Contact Author)

University of Notre Dame - Mendoza College of Business ( email )

Notre Dame, IN 46556-5646
United States

HOME PAGE: http://chenwang.one/

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