Monetary Policy and Treasury Risk Premia

Abstract

This paper investigates the role of monetary policy as a source of time-varying priced risk in bond markets. We use individual agents forecasts of Federal Funds, GDP and inflation to construct an empirical proxy for policy shocks from the residuals of Taylor rule regressions. Key to our analysis is a distinction between (pro-cyclical) target rate shocks and (counter-cyclical) path shocks. We show that path shocks account for between 10% − 15% of the variance of one-year expected excess returns on bonds with maturities 2 − 5 years and are also priced in the cross-section of equity returns.JEL classification: G12, E43, E52

Does Central Bank Tone Move Asset Prices?

“…On a general level, our work relates to previous research that analyzes the effect of monetary policy on asset prices and risks (e.g., Rigobon and Sack, 2004;Bjornland and Leitermo, 2009;Buraschi et al, 2014;Campbell et al, 2015). We also contribute to the literature that quantifies monetary policy shocks in terms of market prices (e.g., Kohn and Sack, 2004;Guerkaynak et al, 2005;Brand et al, 2010;Krishnamurthy and Vissing-Jorgensen, 2011;Hanson and Stein, 2014;Chodorow-Reich, 2014).…”

Forecasting the LIBOR‐Federal Funds Rate Spread During and After the Financial Crisis

“…The literature has extensively employed the BCFF consensus forecasts as survey gauges of macroeconomic (Batchelor & Dua, ; Bauer, Eisenbeis, Waggoner, & Zha, , among others) and financial expectations (Baghestani, ; Chun, ; Buraschi, Carnelli, & Whelan, ; Ichiue & Yuyama, , among others). While other notable surveys exist, survey expectations of the three month LIBOR are available only in the BCFF survey.…”

“…The significant increases in the LIBOR‐FF spread during recessions and periods of financial turmoil suggest that a predictor of risk premiums in the bond market is likely to be a useful predictor of LIBOR‐FF. In recent work, Buraschi, Carnelli, and Whelan () provide empirical evidence of a significant co‐movement between the factor and a measure of monetary policy surprises. Given that monetary policy is likely to have pervasive effects on the LIBOR‐FF spread, the factor will also be a useful gauge of the effect of changes in the monetary policy stance on the LIBOR‐FF spread.…”

Monetary Policy Surprises, Investment Opportunities, and Asset Prices

“…Buraschi, Carnelli and Whelan (2014) also form a monthly frequency measure of monetary policy shocks. They focus on shocks to the expected future path of monetary policy based on a combination of survey data and a Taylor (1993) rule.…”