Under- and Over-Reaction in Yield Curve Expectations

98 Pages Posted: 5 Dec 2019 Last revised: 14 Apr 2020

See all articles by Chen Wang

Chen Wang

University of Notre Dame - Mendoza College of Business

Date Written: March 1, 2020

Abstract

I study how professional forecasts of interest rates across maturities respond to new information. I document that 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 (March 1, 2020). 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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