The Bond Market is Excitable

Prof. Hamilton at Econbrowser commented on a speech by Bernanke in which variability of inflation expectations was discussed. JDH went on to reference a very good academic paper, The Excess Sensitivity of Long-Term Interest Rates: Evidence and Implications for Macroeconomic Models in which these effects are quantified.

Of course, that paper is nearly four years old now. In the interim, there have been expressions of regret for the disappearance of bond market vigilantes; this apparent disappearance is probably due also to indiscrimate buying by the Chinese as much as anything else. Also, probably, due to the fact that idiots such as myself, who have been saying for years that inflation of 2%-ish should mean Canadian 10-year-yields of 4.75-5.25%-ish have had our heads handed to us on a 3.75% plate.

Anyway, the paper is a good one. Abstract:

This paper demonstrates that long-term forward interest rates in the U.S. often react considerably to surprises in macroeconomic data releases and monetary policy announcements. This behavior is inconsistent with the assumption of many macroeconomic models that the long-run properties of the economy are time-invariant and perfectly known by all economic agents. Under those conditions, the shocks we consider would have only transitory effects on short-term interest rates, and hence would not generate large responses in forward rates. Our empirical findings suggest that private agents adjust their expectations of the long-run inflation rate in response to macroeconomic and monetary policy surprises. Consistent with our hypothesis, forward rates derived from inflation-indexed Treasury debt show little sensitivity to these shocks, indicating that the response of nominal forward rates is mostly driven by inflation compensation. In addition, we find that in the U.K., where the long-run inflation target is known by the private sector, long-term forward rates have not demonstrated excess sensitivity since the Bank of England achieved independence in mid-1997. We present an alternative model in which agents’ perceptions of long-run inflation are not completely anchored, which fits all of our empirical results.

6 Responses to “The Bond Market is Excitable”

  1. […] The most interesting part of all this, however, is that the spectre of inflation is intruding more often into public debate. Should stagflation become a more credible threat than it is now, I suspect policy makers will favour the stag- over the -flation and tighten even faster than they are currently easing … which could have major implications for long-bonds and therefore preferreds. […]

  2. […] Rule #1 states that the world always looks more interesting than it really is, an idea mentioned in a previous post, The Bond Market is Excitable. James Hamilton of Econbrowser took a look at the retail sales numbers that had everybody so excited yesterday and yawned. […]

  3. […] I’m appalled, frankly. If the Fed is trying to inflate its way out of the credit crunch, the yield curve should be WAY steeper than it is now … let’s say inflation becomes a large-but-not-disastrous 3% … and we want 2% real-yield on 10-years (at least! 2% is skimpy) … my calculator must be broken, I get an answer that’s nowhere near 3.5%. Where are the bond vigilantes when you need them? […]

  4. […] Sit tight, do your homework, turn off the TV and stare at financial statements until you’re crosseyed, that’s the path to success. The bond market is excitable and always will be … ignore it, keep your company-specific bets small, your leverage non-existant and have another look at them financial statements. […]

  5. […] other words … the bond market is excitable, so let’s just feed it […]

  6. […] the paper provides further evidence that the bond market is excitable: In contrast to public measures of bank risk (such as CDS prices), which varied widely both […]

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