Under- and Over-Reaction in Yield Curve Expectations

98 Pages Posted: 5 Dec 2019

See all articles by Chen Wang

Chen Wang

Yale School of Management

Date Written: November 16, 2019


I study how professional forecasts of interest rates across maturities respond to new information. I confirm and provide additional evidence for a pattern noted by Bordalo et al. (2019b): forecasts for short-term rates underreact to new information while forecasts for long-term rates overreact. I propose a new explanation based on “autocorrelation averaging,” whereby, due to limited cognitive processing capacity, forecasters’ estimate of the autocorrelation of a given process is biased toward the average autocorrelation of all the processes they observe. Consistent with this view, I show that forecasters over -estimate the autocorrelation of the less persistent term premium component of interest rates and under -estimate the autocorrelation of the more persistent short rate component. A calibrated model quantitatively matches the documented pattern of misreaction. Finally, I explore the pattern’s implication for asset prices. I show that an overreaction-motivated predictor, the realized forecast error for the 10-year Treasury yield, robustly predicts excess bond returns.

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

JEL Classification: D83, E43, G12

Suggested Citation

Wang, Chen, Under- and Over-Reaction in Yield Curve Expectations (November 16, 2019). Available at SSRN: https://ssrn.com/abstract=3487602 or http://dx.doi.org/10.2139/ssrn.3487602

Chen Wang (Contact Author)

Yale School of Management ( email )

165 Whitney Ave PhD Suite
New Haven, CT 06511
United States

HOME PAGE: http://chenwang.one

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