Executive Summary

  • The history of the bond market reveals a conundrum: Yields have swung from high levels in the 1970s to low levels today. The usual explanatory factors are inflation trends, the natural rate and the bond risk premium. Conventional measures of these factors show up-and-down swings, but collectively they do not add up. They overexplain yields, so some of these explanations are incorrect or exaggerated.
  • We address this puzzle with a new model that estimates the contribution of the three factors in a mutually consistent way. We obtain market-implied measures of the unobservable natural rate r* and bond risk premia consistent with observable bond market yields and trend inflation π*.
  • With the incorporation of bond market data, ignored in other r* models, our market-implied natural rate and bond risk premium differ from established estimates. Our natural rate r* is typically much lower over the sample, especially in recent years, intensifying current concerns about secular stagnation and the effective lower bound on monetary policy in advanced economies. Our bond risk premium varies much less over time and is higher today than in other models.
  • The results are important for investors. In particular, judged on a month-to-month basis, our trend factors improve the fit of linear predictions of yields and excess returns. In addition, although conventional estimates say the bond risk premium has been mostly negative in the past decade, our market-implied bond risk premium estimate has maintained an average above zero.

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The Author

Josh Davis

Global Head of Client Analytics

Joachim Fels

Global Economic Advisor

Alan M. Taylor

Professor of Economics and Finance, University of California, Davis

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