The Natural Rate Puzzle
- 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.
The analysis contained in this paper is based on hypothetical modeling. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program or strategy.
One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading or modeling does not involve financial risk, and no hypothetical example can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses, are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.
Figures are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.
There is no such thing as a “safe asset” or “safe debt”. These assets are typically referred to as a "risk-free" asset, which refers to an asset which in theory has a certain future return. U.S. Treasuries are typically perceived to be the "risk-free" asset because they are backed by the U.S. government. All investments contain risk and may lose value.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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