Monetary Policy and Bond Prices with Drifting Equilibrium Rates

Abstract

We study drift and cyclical components in U.S. Treasury bonds. We find that bond yields are drifting because they reflect the drift in monetary policy rates. Empirically, modeling the monetary policy drift using demographics and productivity trends, plus long-term inflation expectations, leads to cyclical deviations of bond prices from their drift that predict bond returns in- and out-of-sample. These bond cycles can originate from term premia or temporary deviations from rational expectations in a behavioral framework. Through the lens of our model, we detect a significant role of the latter in determining the cyclical properties of yields with short maturities.

Keywords: Bond Return Predictability, Diagnostic expectations, Monetary Policy Rule, Secular Trends, term structure

JEL Classification: E43, E52, G12