Bonds, Currencies and Expectational Errors

53 Pages Posted: 30 Apr 2020

Date Written: April 30, 2020

Abstract

We propose a model in which sticky expectations concerning shortterm interest rates generate joint predictability patterns in bond and currency markets. Using our calibrated model, we quantify the effect of this channel and find that it largely explains why short rates and yield spreads predict bond and currency returns. The model also creates the downward sloping term structure of carry trade returns documented by Lustig et al. (2019), difficult to replicate in a rational expectations framework. Consistent with the model, we find that variables that predict bond and currency returns also predict surveybased expectational errors concerning interest and FX rates. The model explains why monetary policy induces drift patterns in bond and currency markets and predicts that long-term rates are a better gauge of market’s short rate expectations than previously thought.

Keywords: Bond and currency premia, sticky expectations, interest rate forecast errors

JEL Classification: E43, F31, D84

Suggested Citation

Granziera, Eleonora and Sihvonen, Markus, Bonds, Currencies and Expectational Errors (April 30, 2020). Bank of Finland Research Discussion Paper No. 7/2020, Available at SSRN: https://ssrn.com/abstract=3589692

Eleonora Granziera

Bank of Finland ( email )

Snellmaninaukio
Helsinki, Helsinki 00100
Finland

HOME PAGE: http://https://sites.google.com/site/eleonoragranziera/

Markus Sihvonen (Contact Author)

Bank of Finland ( email )

P.O. Box 160
Helsinki 00101
Finland

HOME PAGE: http://sites.google.com/site/mesihvonen/

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