A Portfolio-Balance Approach to the Nominal Term Structure

Abstract

I examine how the maturity structure of outstanding government li- abilities aects the nominal yield curve under a variety of assumptions about investor objectives. In the class of models I consider, equilib- ria are arbitrage free, expectations are rational, and assets are valued only for their pecuniary returns. Nonetheless, a portfolio-balance mech- anism arises through the dependence of the pricing kernel on the return on wealth. This mechanism results in a positive relationship between the duration of bondholders'portfolios and the price of interest-rate risk. Quantitatively, the models suggest that the eects of shifting Treasury supply on yields can be substantial— for example, the increase in the av- erage maturity of U.S. government debt that occurred between 1976 and 1988 may have raised the ten-year yield by 50 basis points. On the other hand, partly re‡ecting an attenuation of portfolio-balance eects when in- terest rates are near zero, the Federal Reserve's asset purchase programs likely had a fairly small impact on the yield curve by removing duration from the market.