Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds
The covariance between US Treasury bond returns and stock returns has moved considerably over time. While it was slightly positive on average in the period 1953-- 2005, it was particularly high in the early 1980's and negative in the early 2000's. This paper specifies and estimates a model in which the nominal term structure of interest rates is driven by four state variables: the real interest rate, risk aversion, expected inflation, and the covariance between nominal variables and the real economy. Log nominal bond yields and term premia are quadratic in these state variables, with term premia determined mainly by the product of risk aversion and the nominal-real covariance. The concavity of the yield curve-the level of intermediate-term bond yields, relative to the average of short- and long-term bond yields-is a good proxy for the level of term premia.
This research was supported by the U.S. Social Security Administration through grant #10-P-98363-1-04 to the National Bureau of Economic Research as part of the SSA Retirement Research Consortium. The findings and conclusions expressed are solely those of the authors and do not represent the views of SSA, any agency of the Federal Government, or the NBER. We also acknowledge the support of the National Science Foundation under grant no. 0214061 to Campbell, and of Harvard Business School Research Funding to Viceira.