Macro Expectations, Aggregate Uncertainty, and Expected Term Premia

The empirical term structure literature shows that long-term interest rates are not merely a combination of expected short-term interest rates and a constant risk premium, as the so-called Expectation Hypothesis would suggest. Rather, the risk premium for holding long-term bonds varies over time and is predictable to a certain extent as shown by a multitude of studies. The economic reasons behind the movement of these risk premia are thus of special interest for monetary policy seeking to influence long-term market interest rates through a short-term key interest rate. Our study contributes to a better understanding of risk premia in bond markets by explicitly analyzing expectations about bond risk premia. This analysis is based on individual data from the Survey of Professional Forecasters (SPF), conducted by the Federal Reserve Bank Philadelphia among forecasters from banks, financial institutions, and research institutions in the United States. We empirically show that expectations about risk premia are significantly influenced by expectations about real macroeconomic activity (such as GDP), while nominal factors (such as inflation expectations) play a minor role. The uncertainty of forecasters about future business cycle movements also has a pronounced effect on risk premium expectations. Our results indicate that expected risk premia are positively correlated with expectations about GDP and inflation. Higher uncertainty with respect to macroeconomic variables also increases expected risk premia. We also examine how the shape of the yield curve is related to expected risk premia. For instance, the curvature of the yield curve can be explained by information which is also captured by the expected change in risk premia of forecasters in the SPF. Finally, we show that the expected changes in risk premia actually do forecast bond excess returns. This underlines that our proxy for risk premium expectations is indeed informative for developments in bond markets.

Dick, Christian, Maik Schmeling and Andreas Schrimpf (2010), Macro Expectations, Aggregate Uncertainty, and Expected Term Premia, ZEW Discussion Paper No. 10-064, Mannheim.