Real Bond Yields Research Articles

Breakeven Inflation Rates and Their Puzzling Correlation Relationships

It is generally assumed that the two Fisher components of the interest rate -the real interest and the inflation- evolve independently over time, considering that they are driven by unrelated economical events. However, the market pricing of those components deduced from newly-available bond data does not provide conclusive evidence. While studying the price behavior of inflation-linked (real) bonds beside nominal bonds in the major fixed-income markets, we observe that the real bond yields and the yield differentials, the breakeven inflation rates, have the propensity to be positively correlated between each other across the various countries, yet are pushed into a negative correlation relationship due to market-related price distortions. As long as those distortions are local, the net result is near-zero correlation within countries; when they become global, as in the heat of the current crisis, the correlations turn negative worldwide. In this paper insight is gained by taking an innovative worldwide study approach and thanks to revealing crisis period events.

Nominal Bonds, Real Bonds, and Equity

We decompose the term structure of expected equity returns into (1) the real short rate, (2) a premium for holding real long-term bonds, or the real duration premium, the excess returns of nominal long-term bonds over real bonds which reflects (3) expected inflation and (4) inflation risk, and (5) a real cashflow risk premium, which is the excess return of equity over nominal bonds. The shape of the nominal and real bond yield curves are upward sloping due to increasing duration and inflation risk premiums. The term structures of expected equity returns and equity risk premiums, in contrast, are downward sloping due to the decreasing effect of short-term expected inflation, or trend inflation, across horizons. Around 70% of the variation of expected equity returns at the 10-year horizon is due to variation in the output gap and trend inflation.

Inflation Expectations and Risk Premiums in an Arbitrage‐Free Model of Nominal and Real Bond Yields

Differences between yields on comparable‐maturity U.S. Treasury nominal and real debt, the so‐called breakeven inflation (BEI) rates, are widely used indicators of inflation expectations. However, better measures of inflation expectations could be obtained by subtracting inflation risk premiums (IRP) from the BEI rates. We provide such decompositions using an affine arbitrage‐free model of the term structure that captures the pricing of both nominal and real Treasury securities. Our empirical results suggest that long‐term inflation expectations have been well anchored over the past few years, and IRP, although volatile, have been close to zero on average.

Equilibrium Asset Prices and Investor Behaviour in the Presence of Money Illusion

This article analyses the implications of money illusion for investor behaviour and asset prices in a securities market economy with inflationary fluctuations. We provide a belief-based formulation of money illusion which accounts for the systematic mistakes in evaluating real and nominal quantities. The impact of money illusion on security prices and their dynamics is demonstrated to be considerable even though its welfare cost on investors is small in typical environments. A money-illusioned investor's real consumption is shown to generally depend on the price level, and specifically to decrease in the price level. A general-equilibrium analysis in the presence of money illusion generates implications that are consistent with several empirical regularities. In particular, the real bond yields and dividend price ratios are positively related to expected inflation, the real short rate is negatively correlated with realized inflation, and money illusion may induce predictability and excess volatility in stock returns. The basic analysis is generalized to incorporate heterogeneous investors with differing degrees of illusion.

Inflation Expectations and Risk Premiums in an Arbitrage-Free Model of Nominal and Real Bond Yields

Differences between yields on comparable-maturity U.S. Treasury nominal and real debt, the so-called breakeven inflation (BEI) rates, are widely used indicators of inflation expectations. However, better measures of inflation expectations could be obtained by subtracting inflation risk premiums from the BEI rates. We provide such decompositions using an estimated affine arbitrage-free model of the term structure that captures the pricing of both nominal and real Treasury securities. Our empirical results suggest that long-term inflation expectations have been well anchored over the past few years, and inflation risk premiums, although volatile, have been close to zero on average.

Extracting inflation expectations and inflation risk premia from the term structure: A joint model of the UK nominal and real yield curves

This paper analyses the UK interest rate term structure over the period since October 1992, when the United Kingdom adopted an explicit inflation target, using an affine term structure model estimated using both government bond yields and survey data. The model imposes no-arbitrage restrictions across nominal and real yields, which enables interest rates to be decomposed into expected real policy rates, expected inflation, real term premia and inflation risk premia. The model is used to shed light on major developments over the period, including the impact of Bank of England independence and the low real bond yield ‘conundrum’.

The Ties that Bind: Measuring International Bond Spillovers Using Inflation-Indexed Bond Yields

This paper explores international bond spillovers using daily and weekly data on yields on inflation-indexed bonds and associated inflation expectations for the United States, Australia, Canada, France, Sweden, Japan, and the United Kingdom. The analysis starts in 2002, by which point U.S. inflation-indexed markets had matured. Real bond yields are found to be closely linked across countries, with developments in U.S. markets determining around half of real foreign yields and no evidence of spillovers back to the United States. Spillovers in inflation expectations are smaller and the direction of causation is less clear.

Asset Pricing with Left-Skewed Long-Run Risk in Durable Consumption

I document that durable consumption growth is persistent and predicted by the price-dividend ratio. This provides strong and direct evidence for the existence of a highly persistent expected component. I also document robust evidence that durable consumption growth is left skewed and exhibits time-varying volatility. Based on these empirical properties, I model durable consumption growth as containing a persistent expected component and driven by shocks with counter-cyclical volatility. I embed the durable consumption growth dynamics and random walk nondurable consumption growth in nonseparable Epstein-Zin preferences, and model dividend growth as a levered claim on the expected component of durable consumption growth. The resulting model can explain a number of asset pricing phenomena, including pro-cyclical price-dividend ratios, large and counter-cyclical equity premia and stock return volatilities, low and smooth risk-free rates, and the predictability of stock returns. The model also generates the volatility feedback effect and an upward sloping term structure of real bond yields.

Long-term interest rates and expected future budget deficits: evidence from the term structure

This article examines the relationship between current and expected future real Treasury bond yields, forecasts of budget deficits and market risk. Both expected future deficits and risk strongly influenced expected future real Treasury bond yields in the United States in the 1983–2005 period.

The Ties That Bind: Measuring International Bond Spillovers Using the Inflation-Indexed Bond Yields

This paper explores international bond spillovers using daily and intra-day data on yields on inflation-indexed bonds and associated inflation expectations for the United States, Australia, Canada, France, Sweden, Japan, and the United Kingdom. The analysis starts in 2002, by which point U.S. inflation-indexed markets were fully mature. Real bond yields are found to be closely linked across countries, with developments in U.S. markets determining around half of real foreign yields and no evidence of spillovers back to the United States. Spillovers in inflation expectations are smaller and the direction of causation is less clear.

Is there a global bonds bubble ‐ what if it bursts?

Both real and nominal bond yields have fallen to historically low levels, and in the US the yield curve has been inverted (that is, two‐year yields have been above ten‐year yields) or very flat since the start of December. This article by Jonathan Hoffman and Keith Church discusses the possible reasons for these developments ‐ including the 'savings glut' proposed by the new Fed Chairman Bernanke ‐ as well as the likelihood of a sharp sell‐off of bonds. It then looks at precedents for a sell‐off but concludes that there are few parallels between the current situation and the earlier episodes. Finally, it identifies possible triggers for a sell‐off and presents a simulation with the OEF Global Model to analyse the likely consequences for the world economy. The conclusion is that, while a rise in US yields to 6.5% in the first half of 2007 would cut growth significantly, including through a fall of almost 1% point in the growth rate of household consumption in the US in 2008, its impact would not be catastrophic.

Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion: A Preference-Based Formulation

This article analyzes the implications of money illusion for investor behavior and asset prices in a securities market economy with inflationary fluctuations. Money illusion is modeled as an investor's partial overlooking the impact of inflation on the purchasing power of currency in his intertemporal decision making. The impact of money illusion on security prices and their dynamics is demonstrated to be considerable even though its utility cost on investors is small in typical environments. A money-illusioned investor's real consumption is shown to generally depend on the price level, and specifically to decrease in the price level for relative risk aversion higher than unity. A general-equilibrium analysis in the presence of money illusion generates implications that are consistent with several empirical regularities. In particular, the real bond yields and dividend price ratios are positively related to expected inflation, the real short rate is negatively correlated with realized inflation, and money illusion may induce predictability and excess volatility in stock returns. The basic analysis is generalized to incorporate heterogeneous investors with differing degrees of illusion and to a monetary economy with endogenous inflation.

Bond Return Predictability: An Investigation for the European Market

The predictability of security returns has received considerable attention in the finance literature. Notwithstanding, the predictability of bond returns, in particular outside the US, has been far less explored. In this paper we analyse the ability of several predetermined information variables in predicting bond returns in the European market. We test if variables, commonly used for that matter in the context of other markets (such as inverse relative wealth, term spread, real bond yield and a January dummy) are also useful predictors of European bond returns. Due to some particularities of the sample period of analysis, characterised by the EMU convergence, we also make another contribution by including the yield spread in relation to German bonds. Furthermore, we analyse the return predictability across different bond maturities: 1-3, 3-5 and 5 or more years to maturity. The results indicate that variables like the term spread, IRW and a January dummy represent useful information in order to predict bond returns for different maturities. The other two variables add little in terms of explanatory power. Surprisingly, the DM yield spread does not seem to have any predictive ability for the countries expected to participate in the EMU. However, a puzzling result was obtained: this variable appears to be significant for the UK market! Additionally, we find that investors, using simple trading strategies that exploit this information, may obtain higher returns. This outperformance is observed for different maturities, being more evident for long-term Government bonds. These findings may have important implications on other related issues such as market efficiency, asset pricing and portfolio performance evaluation.

Matched-Long Term Maturity Stock and Bond Returns in International Markets

This paper examines the relationship between real stock returns and matched-maturity long-term bond yields for 16 countries. We find a strong positive correlation between real stock returns and corresponding matched-maturity long-term bond returns for every country in the sample. Our findings also indicate that the volatility of long term real stock returns is closely related to the volatility of long term real bond yields. Finally, an additional cross-sectional analysis indicates that the sensitivity of real stock returns to real bond yields in each country is negatively related to the average rate of inflation and the coefficient of variation of these inflation rates.

Determinants of New Zealand Bond Yields

This paper examines the driving factors of New Zealand bond yields over the 1988-1997 period. The results indicate that: . the general analytical framework implied by the Uncovered Interest Parity (UIP) relation finds some support in the data. . in the long run, short term real bond yields are related to US real bond yields, currency expectations and expectations of the future stance of domestic monetary policy vis a vis the stance offshore. . long-term real bond yields are related to Australian real bond yields, currency expectations, inflation uncertainty and relative monetary policy expectations. . in recent years, domestic bond yields have been more closely related to offshore yields suggesting increased integration between the domestic and international capital markets. . increased perceptions of political risk appears to have played an important role in the rise in domestic long bond yields during the first half of 1996.

Reexamining Stock Valuation and Inflation: The Implications of Analysts' Earnings Forecasts

This paper examines the effect of expected inflation on stock prices and expected long-run returns. An ex ante estimates measure of expected long-run returns is derived by incorporating estimates of expected of future corporate cash flows into a variant of the Campbell-Shiller dividend-price ratio model. In this model, the log earnings-price ratio is expressed as a linear function of expected future returns, expected earnings growth rates, and the log of the current dividend-payout ratio. Expectations of earnings growth are inferred from equity analysts' earnings forecasts, while inflation expectations are drawn from surveys of professional forecasters. I find that the negative relation between equity valuations and expected inflation results from two effects: higher expected inflation coincides with (i) lower expected real earnings growth and (ii) higher required real returns. The earnings channel is not merely a reflection of inflation's recession-signalling properties; rather, much of the negative valuation effect results from a negative relation between expected inflation and expected longer-term real earnings growth. The effect of expected inflation on required (long-run) real stock returns is also substantial. A one percentage point increase in expected inflation raises required real stock returns about one percentage point, which on average implies a 20 percent decline in the level of stock prices. The inflation-related component of expected real stock returns is closely related to the component explained by real long-term bond yields.

Forecasting U.S. Bond Returns

The author examines the ability of variables such as steepness of the yield curve, real bond yield, recent stock market performance, and bond market momentum to predict bond returns. He shows that these indicators are more effective at predicting returns collectively than individually. He uses historical data to back test static and active investment strategies tied to these predictors. Not all investors are willing to replicate these allocation methods, because the forecasts are incorrect 40 percent of the time and expected losses in the short term may be viewed as a high cost to bear for potential long-term gains.

Real Interest Rates: Past and Future

Before 1914 long-term price stability was confidently expected in the UK. The typical yield then of 3 per cent per annum on long-term UK government bonds can be compared with the 4 per cent per annum on government index-linked bonds at end-1992. Inflation has made conventional long-term Government bonds riskier, and it is estimated that the real expected yield on these was about 5 per cent per annum at end-1992. Estimates are also provided for years in between, and for expected real returns on equities, and for the US, and these may surprise some. As estimated, expected real long-term UK government conventional bond yields were mostly at or above 4 per cent per annum. As bonds became relatively more risky, the risk premium on equities came down and is currently quite small, so that the cost of equity capital has not risen as has the cost of government conventional bond borrowing. In the absence o f a prolonged world depression, it seems likely that current expected real long-term interest rates will not f...