Abstract
I provide empirical evidence of changes in the U.S. Treasury yield curve and related macroeconomic factors, and investigate whether the changes are brought about by external shocks, monetary policy, or by both. To explore this, I characterize bond market exposures to macroeconomic and monetary policy risks, using an equilibrium term structure model with recursive preferences in which inflation dynamics are endogenously determined. In my model, the key risks that affect bond market prices are changes in the correlation between growth and inflation and changes in the conduct of monetary policy. Using a novel estimation technique, I find that the changes in monetary policy affect the level of bond yields through their effect on expected inflation, while the changes in the correlation between growth and inflation affect both the level as well as the volatility of bond yields. Consequently, the changes in the correlation structure are the main contributor to bond risk premia and to bond market volatility. The time variations within a regime and risks associated with moving across regimes lead to the failure of the Expectations Hypothesis and to the excess bond return predictability regression of Cochrane and Piazzesi (2005), as in the data.
Highlights
There is mounting evidence that the U.S Treasury yield curve and relevant macroeconomic factors have undergone structural changes over the past decade
Among them are a flattening of the yield curve and a substantial drop in the degree of time variation in excess bond returns
I study the role of structural changes in the macroeconomic factors as well as in the conduct of monetary policy in explaining the bond market changes over the last decade
Summary
There is mounting evidence that the U.S Treasury yield curve and relevant macroeconomic factors have undergone structural changes over the past decade. Pflueger, and Viceira (2013) examine the role of monetary policy using a New Keynesian model and David and Veronesi (2013) explore the time-varying signaling role of inflation in a consumption-based model My work complements these two studies because it studies the role of structural changes in the macroeconomic factors as well as in the conduct of monetary policy in a unified framework, and investigates their role in explaining the bond market fluctuations. By investigating time variation of the stance of monetary policy, my work contributes to the monetary policy literature, e.g., Clarida, Gali, and Gertler (2000), Coibon and Gorodnichenko (2011), FernandezVillaverde, Guerron-Quintana, and Rubio-Ramırez (2010), Lubik and Schorfheide (2004), Schorfheide (2005), and Sims and Zha (2006).4 While most of these papers study the impact of changes in monetary policy on macroeconomic aggregates, Ang, Boivin, Dong, and Loo-Kung (2011) and Bikbov and Chernov (2013) focus on their bond market implications (using reduced-form modeling frameworks).
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