Commodity Tails and Bond Risk Premia

Abstract

Commodity tail risk predicts bond excess returns, both theoretically and empirically. Commodity price jumps cause inflation to deviate from the target rate set by the Taylor rule -- arousing a central bank response of unknown size. This monetary uncertainty affects long-term but not short-term bonds. As especially large shifts trigger central bank reactions, tail risk predicts bond returns better than volatility. These findings are supported in- and out-of-sample: Commodity up-tail (down-tail) significantly predicts bond returns with out-of-sample R-squares up to 19.07% (5.77%). It is unspanned by the yield curve and existing predictors. Robustness occurs across sub-periods and for international markets.