Treasuries variance decomposition and the impact of monetary policy

Abstract

This paper investigates the effect of monetary policy shifts on Treasuries over the last three decades. We decompose unexpected excess returns on 2‐, 5‐, and 10‐year Treasuries in three components related to revisions in expectations (news) about future excess returns, inflation, and real interest rates. We evaluate the impact of conventional and unconventional monetary policy shocks on returns and their components. Our results indicate that expansionary monetary policy shocks are associated with declining inflation expectations and higher Treasuries' returns.

Monetary Policy and Corporate Bond Returns

“…In sum, our results for corporate bonds strongly support the importance of discount rate news, as a driver of the total variability of returns, in agreement with studies that conduct variance decomposition for stocks at the market level (Campbell, 1991;Campbell and Ammer, 1993;Bernanke and Kuttner, 2005;Maio, 2014;Maio and Philip, 2015). On the other hand, previous studies on Treasuries find that inflation news is the main component of unexpected excess bond returns (Campbell and Ammer, 1993;Engsted and Tanggaard, 2007;Kontonikas et al, 2015). These results provide additional evidence on the distinct behavior of Treasury and corporate bond returns.…”

“…To do so, we use data on FFR futures and the methodology employed by Kuttner (2001). This market-based proxy of policy shocks has been widely used in the literature that examines the impact of monetary policy on stocks and bonds (Bernanke and Kuttner, 2005;Bredin et al, 2010;Cenesizoglu and Essid, 2012;Kontonikas et al, 2015). The month t + 1 monetary policy shock (M P ) is calculated as follows:…”

“…The primacy of risk premia news is typical in previous return decomposition studies that examine stocks at the market level (Campbell, 1991;Campbell and Ammer, 1993;Bernanke and Kuttner, 2005), but not in studies that analyse Treasury bonds. 6 The latter tend to identify other components (inflation news) as the key driver of excess bond returns (Campbell and Ammer, 1993;Engsted and Tanggaard, 2007;Kontonikas et al, 2015). Hence, the type of borrower (sovereign versus corporations) seems to play an important role on the reaction of investors to fundamental news.…”

Divergence of sentiment and stock market trading

“…In particular, we control for surprises related to the change in inflation, the growth rate of industrial production, the change in non-farm payrolls, the growth rate of retail sales, the change in unemployment, and the change in house prices. These variables are available monthly and follow from Bernanke and Kuttner (2005) and Kontonikas et al (2015). We let these variables enter our regression in absolute form.…”