Nominal Yield Curve Research Articles

Salience effect and yield curve

This paper studies the influence of salience on nominal and real yield curves by introducing the salience effect in the Piazzesi and Schneider model (hereafter PS). We construct the salience values based on the expected consumption growth using U.S. data. We find that salience values are negatively correlated with the expected consumption growth rates. Based on U.S. data from 1960q1 to 2020q4, we find that the salience model can generate upward nominal and real yield curves within reasonable risk aversion coefficients (less than 10), as well as well-fitted average yields with actual data. The salience model compensates for the PS or recursive preference model’s inability to generate an upward nominal or real yield curve within reasonable risk aversion. Furthermore, we provide empirical support for model implications.

How far can the long-run risk model with durable goods explain the variation of the yield curve?

A consumption-based, long-run risk equilibrium model with nondurable and durable goods is estimated using US nominal interest rate data. The model generates upward-sloping nominal yield curves and nearly flat real yield curves, implying that the term structure of inflation risk premia is upward-sloping. Though both nondurable and durable consumption have statistically significant explanatory power for the movement of the short-term nominal rate, the overall explanatory power of the model is small. The estimated relation between the durable consumption growth and stochastic discount factor is opposite to that in previous studies that estimate similar models with equity data.

Regime shifts in a long-run risks model of stock and treasury bond markets

PurposeThis paper aims to study the asset pricing implications for stock and bond markets in a long-run risks (LRR) model with regime shifts. This general equilibrium framework can not only generate sign-switching stock-bond correlations and bond risk premium, but also quantitatively reproduce various other salient empirical features in stock and bond markets, including time-varying equity and bond return premia, regime shifts in real and nominal yield curves, the violation of the expectations hypothesis of bond returns.Design/methodology/approachThe researchers study the joint determinants of stock and bond returns in a LRR model framework with regime shifts in consumption and inflation dynamics. In particular, the means, volatilities, and the correlation structure between consumption growth and inflation are regime-dependent.FindingsThe model shows that the term structure of interest rates and stock-bond correlation are intimately related to business cycles, while LRR play a more important role in accounting for high equity premium than do business cycle risks.Originality/valueThis paper studies the joint determinants of stock and bond returns in a Bansal and Yaron (2004) type of LRR framework. This rational expectations general equilibrium framework can (1) jointly match the dynamics of consumption, inflation and cash flow; (2) generate time-varying and sign-switching stock and bond correlations, as well as generating sign-switching bond risk premium; and (3) coherently explain another long list of salient empirical features in stock and bond markets, including time-varying equity and bond return premia, regime shifts in real and nominal yield curves, the violation of the expectations hypothesis of bond returns.

Break-even inflation rates: the Italian case

PurposeThis work aims to study the break-even inflation rates (BEIRs), a widely used market-based measure of expected inflation. The authors focus on Italian Government bonds, one of the most liquid debt markets in the euro area.Design/methodology/approachThe authors set up an auto-regressive distributed lag model and regress the BEIR on a set of variables that proxy inflation, market risk aversion, protection against deflation, credit as well as liquidity risk to get some insights into the importance of these factors. Subsequently, to disentangle market participants’ inflation expectations from their associated risk premia, the authors estimate a term structure model for the joint pricing of the Italian Government’s nominal and real yield curves, considering also a credit and a liquidity pricing factor.FindingsThe results show that BEIRs could be a misleading measure of the expected inflation due to the importance of the inflation risk premium and the credit risk effect. According to the estimates, the decrease of market-based measures of inflation observed in the last part of the sample period seems to reflect a lowering of both inflation expectations and risk premia. Inflation premia co-move with a measure of the tail risk of the long-term inflation distribution, signalling that investors become more concerned with downside risks.Originality/valueThis study complements the existing literature primarily based on the USA and euro area data focusing on the Italian market. To this end, the authors modify and adapt a well-known term structure model developed for nominal and real curves.

Regime Shifts in a Long-run Risks Model of U.S. Stock and Treasury Bond Markets

I study the joint determinants of stock and bond returns in Bansal and Yaron (2004) long-run risks model framework with regime shifts in consumption and in‡ation dynamics –in particular, the means, volatilities, and the correlation structure between consumption growth and in‡ation are regime-dependent. This general equilibrium framework can (1) generate time-varying and switching signs of stock and bond correlations, as well as switching signs of bond risk premium; (2) quantitatively reproduce various other salient empirical features in stock and bond markets, including time-varying equity and bond return premia, regime shifts in real and nominal yield curve, the violation of expectations hypothesis of bond returns. The model shows that term structure of interest rates and stock-bond correlation are intimately related to business cycles, while long-run risks play a more important role to account for high equity premium than business cycle risks.

Dissecting the yield curve: The international evidence

We develop a term structure model that decomposes nominal yields into the sum of an expectation, term premium, and convexity term and in turn of their real and inflation counterparts. The model explicitly captures the interrelation between yield-only and macroeconomic factors while allowing for aggregate stochastic volatility. We extract the components from the nominal and real yield curve of the United States, the Euro Area, the United Kingdom, and Japan. We find that short-rate expectations have steadily declined over the last two decades and account for the bulk of yield dynamics. Term premia increase with maturity but explain a smaller fraction of yield forecast error variance than previously documented. With regard to yield comovement, the United States generates the strongest spillovers at the long end of the yield curve, whereas the Japanese market is the top importer of shocks.

Dominant currency debt

We propose a “debt view” to explain the dominant international role of the dollar. Within a simple capital-structure model with debt-currency choice, we show that the “dominant currency” is the one that (1) depreciates in global downturns over horizons of typical debt maturity and (2) has the steepest nominal yield curve. Empirically, we show the dollar fits this description better than other major currencies. The debt view can explain dollar-debt-issuance patterns over the past two decades. It also offers insights into the future of the dominance of the dollar in the aftermath of the COVID-19 crisis.

What Drives the Nominal Yield Curve in Brazil?

This paper describes the dynamics of the level, slope and curvature of the Brazilian nominal yield curve using only observable macroeconomic indicators. The model is able to explain 94.5% of the variation in the yield curve. We find that the main drivers of the level factor is the Brazil risk premium (5-year CDS spread) and the unemployment rate. In turn, the slope steepens with increases either in the SELIC rate or in the spot exchange rate, and flattens with increases in unemployment rate and commodity returns. Lastly, the curvature increases with the unemployment, inflation and SELIC rates, but decreases with changes in the exchange rate.

Optimal investment for a retirement plan with deferred annuities allowing for inflation and labour income risk

We construct an optimal investment portfolio model for an individual investor saving in a retirement plan. The investor earns stochastic labour income with both permanent and temporary shocks, and has access to equity, conventional bond, inflation-indexed bond and cash, as well as two types of deferred annuities: nominal and inflation-protected. The objective function consists of power utility in terms of real retirement income from the annuities as well as bequest from remaining wealth in tradable securities. Asset returns are represented by a vector autoregressive model underpinned by Nelson–Siegel real and nominal yield curves. The optimization problem is solved numerically using multi-stage stochastic programming with a hybrid scenario structure combining a scenario tree with scenario fans. Our numerical results show that deferred annuities are bought early and in increasing amounts during the working lifetime of the investor, with portfolio risk declining with age. Welfare is diminished by 40% if deferred annuities are not available. Inflation-protected deferred annuities are marginally more important in the presence of real labour income risk, but nominal deferred annuities are bought as a cheaper alternative if real yields are low or negative. Portfolio composition and annuity allocation vary depending on financial market expectations, but our central result about the importance of deferred annuities is robust to a variety of financial market conditions.

The Real Explanation of Nominal Bond-Stock Puzzles

We present evidence that the mix of transitory and permanent shocks to consumption is changing over time. We study the implications of this finding for asset prices. The uncovered dynamics of consumption implies modestly upward sloping real bond and equity curves, upward sloping nominal yield curve, and sign-switching correlation between equities and bonds consistent with the stylized facts. This is achieved without relying on the nominal channel too much. That is, as in the data, the variation of inflation in the model is under 40% as a fraction of variation in nominal yields. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

The Real Channel for Nominal Bond-Stock Puzzles

We present evidence that the mix of transitory and permanent shocks to consumption is changing over time. We study the implications of this finding for asset prices. The uncovered dynamics of consumption implies modestly upward sloping real bond and equity curves, upward sloping nominal yield curve, and sign-switching correlation between equities and bonds consistent with the stylized facts. This is achieved without relying on the nominal channel too much. That is, as in the data, the variation of inflation in the model is under 40% as a fraction of variation in nominal yields.

Break-even Inflation Rates: The Italian Case

This paper focuses on break-even inflation rates (BEIRs), a widely used market-based measure of expected inflation, computed from government bonds. In the first part of the paper, we regress the Italian BEIR on several financial variables to assess the contribution of inflation, credit and liquidity components. In the second, in order to disentangle market participants’ inflation expectations from risk premia, we estimate a term structure model for the joint pricing of the Italian nominal and real yield curves, considering also credit and liquidity factors. The results show that BEIRs could be a misleading measure of the expected inflation due to the importance of inflation risk premium and credit risk effect. According to our estimates, the decrease in market-based measures of inflation observed in the last part of the sample period seems to reflect a lowering of both inflation expectations and risk premia. Inflation premia co-move with a measure of tail risk of the long-term inflation distribution signalling that investors become more concerned with downside risks.

Fuel up with OATmeals! The case of the French nominal yield curve

We construct the French nominal yield curve using Svensson33 methodology and all available public data of French nominal government debt securities—Obligations Assimilables du Trésor (OATs). Our sample period starts in October 1987 and ends in April 2018. We find that the functioning of the French sovereign bond market has improved dramatically following the onset of the euro area and has been functioning reasonably well since then, with the exceptions of the Global Financial Crisis period and the European sovereign crisis period. We also find that, the French nominal on-the-run securities have, on average, a negligible liquidity premium, in sharp contrast to the U.S. nominal Treasury market, where such a premium is sizable. On average, the level and the slope of the French zero-coupon rates have been decreasing since the Global Financial Crisis.

Ambiguity, Nominal Bond Yields, and Real Bond Yields

This paper presents an equilibrium bond-pricing model that jointly explains the upward-sloping nominal and real yield curves and the violation of the expectations hypothesis. Instead of relying on the inflation risk premium, the ambiguity-averse agent faces different amounts of Knightian uncertainty in the long run versus the short run; hence the model-implied nominal and real short rate expectations are upward-sloping under the agent’s worst-case equilibrium beliefs. The expectations hypothesis roughly holds under investors’ worst-case beliefs. The difference between the worst-case scenario and the true distribution makes realized excess returns on long term bonds predictable.

Real and Nominal Equilibrium Yield Curves

This paper quantitatively explores the role of external habits, nominal rigidities, and monetary policy for real and nominal bond yields in an asset-pricing endogenous growth model. The calibration captures the reported average positive slopes of U.S. real and nominal yield curves with sizable positive real and nominal bond risk premia. Habits are critical to generate positive real premia by altering the comovement of real rates and productivity shocks. Nominal rigidities generate monetary policy effects on real bonds. Stronger policy rule inflation responses or weaker output responses increase real term premia and reduce inflation risk premia. Relative to standard models, the paper provides an alternative interpretation of real and nominal bond risks. This paper was accepted by Tomasz Piskorski, finance.

How Important are Inflation Expectations for the Nominal Yield Curve?

Less than you think. Relative to the data, standard macro-finance term structure models rely too heavily on the volatility of expected inflation news as a source for variations in nominal yield shocks. In this paper, I develop a nonlinear Bayesian state-space model that accounts for several bond market features, without resorting to an expected inflation channel that counterfactually dominates the variation in nominal yield shocks. The estimation of the model suggests that, for the last two decades, inflation-related risk factors have not played an important role in driving either expected excess bond returns or the term premium component of the nominal yield curve.

How Important Are Inflation Expectations for the Nominal Yield Curve?

AbstractMacrofinance term structure models rely too heavily on the volatility of expected inflation news as a source for variations in nominal bond yield shocks. We develop and estimate a model featuring inflation nonneutrality and preference shocks. The stochastic volatility of inflation and consumption govern bond risk premiums movements, whereas preference shocks generate fluctuations in real rates. The model accounts for key bond market features without resorting to an overly dominating expected inflation channel. The estimation shows that preference shocks are strongly negatively correlated with market distress factors and that real rate news is the dominant driver of nominal yield shocks.

Dissecting the Yield Curve: The International Evidence

We develop a term structure model that decomposes nominal yields into the sum of an expectation, term premium, and convexity term, and in turn of their real and inflation counterparts. The model explicitly captures the interrelation between yield factors and macroeconomic conditions while allowing for aggregate stochastic volatility. We extract the components from the nominal and real yield curve of the US, Euro Area, UK, and Japan. We find that the bulk of yield dynamics comes from short rate expectations. Term premia vary over time and increase with maturity, but account for a smaller fraction of yield variance than previously documented. Over time, we observe a sustained decline in short real rate expectations and significant convexity effects. With regard to yield comovement, the US generates the strongest spillovers at the long-end of the yield curve, whereas the Japanese market is the top importer of shocks.

Ambiguity, Nominal Bond Yields, and Real Bond Yields

This paper presents an equilibrium bond-pricing model that jointly explains the upward-sloping nominal and real yield curves and the violation of the expectations hypothesis. Instead of relying on the inflation risk premium, the ambiguity-averse agent faces different amounts of Knightian uncertainty in the long run versus the short run; hence, the model-implied nominal and real short rate expectations are upward sloping under the agent’s worst-case equilibrium beliefs. The expectations hypothesis roughly holds under investors’ worst-case beliefs. The difference between the worst-case scenario and the true distribution makes realized excess returns on long-term bonds predictable. (JEL D81, D84, E23, E31, E43, E44, G12)

Extracting inflation risk premium from nominal and real bonds using survey information

PurposeThe purpose of this paper is to forecast future inflation using a joint model of the nominal and real yield curves estimated with survey data. The model is arbitrage free and embodies incompleteness between the nominal and real bond markets.Design/methodology/approachThe methodology is based on the affine class of term structure of interest rate. The model is estimated using the Kalman filter technique.FindingsThe authors show that the inclusion of survey data in the estimation procedure improves significantly the inflation forecasting. Moreover, the authors find that the monetary policy has significant effects on the inflation expectation and risk premium.Originality/valueThis paper is the first to estimate inflation using a joint model of nominal and real yield curves with Brazilian data. Moreover, the authors propose a simple arbitrage-free model that takes it account incompleteness between the nominal and real bond markets.