Subjective Expectations and Equilibrium Yield Curves

Abstract

Abstract The stylized facts in the historical dynamics of U.S. Treasury bond yields – a trend in long-term yields, business cycle movements in short-term yields, and a level shift in yield spreads – reflect key features that the pricing kernel of any equilibrium model should have. This paper presents an equilibrium asset pricing model with subjective expectations to jointly explain these puzzling facts. The trend is generated by subjective expectations of long-run GDP growth and inflation, which share similar patterns to the neutral rate of interest (r Star}) and trend inflation (pi Star) estimates in the literature. Cyclical movements in yields and spreads are mainly driven by expected short-run GDP growth and inflation. The less-frequent inverted yield curves (and steeper curve) observed after the 1990s are due to the recent secular stagnation and procyclical inflation expectations.

Keywords: Keywords: Subjective expectations, underreaction, bond yields, neutral rate of interest, trend, cycle, inverted yield curves, secular stagnation

JEL Classification: G00, G12, E43