Expectations and Risk Premia at 8:30 a.m.: Deciphering the Responses of Bond Yields to Macroeconomic Announcements

Abstract

What explains the sharp movements of the yield curve upon the release of major U.S. macroeconomic announcements? To answer this question, we estimate an arbitrage-free dynamic term structure model with macroeconomic fundamentals as risk factors. We assume that the yield curve reacts to announcements primarily because of the information they contain about the fundamentals of output, inflation, and the Fed’s inflation target. We model the updating process by linking the factor shocks to announcement surprises. Fitting this process to data on yield curve movements in 20-min event windows, we find that most major announcements, especially those about the labor market, are informative largely about the output gap rather than about inflation. The resulting changes in short-rate expectations account for the bulk of observed yield movements. But adjustments in risk premia are also sizable. In partly offsetting the effects of short-rate expectations, these adjustments help to account for the well-known hump-shaped pattern of yield reactions across maturities.

KEY WORDS:

• Affine models
• Bond excess returns
• Economic announcements
• Term structure of interest rates.

SUPPLEMENTARY MATERIALS

An online appendix with supplementary material is available.

ACKNOWLEDGMENTS

The authors thank Jens Christensen, David Feldman, Michael Fleming, Mike McCracken, as well as the editor and an anonymous referee. The authors are also grateful for helpful comments from participants at the meetings of the 2012 European Finance Association, the 2013 Computing in Economics and Finance, the 2013 International Banking, Economics and Finance Association, the 2015 Econometric Society World Congress, the 2016 Asian Finance Association conference, and seminar participants at the BIS, Australian National University, Chinese University of Hong Kong, Hong Kong University, Loughborough University, National Taiwan University, University of Nottingham, University of Essex, University of New South Wales, University of the Philippines, the Bangko Sentral ng Pilipinas, and the Central Bank of the Republic of China, Taipei. This work was partly written while Giorgio Valente was visiting the BIS whose hospitality is gratefully acknowledged.

A previous versions of this article was circulated under the title ”Expectations and risk premia at 8:30 am: Macroeconomic announcements and the yield curve.” The views expressed are of authors and do not necessarily reflect those of the BIS or the HKMA.