Working Paper | HBS Working Paper Series | 2013

Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity

by Carolin E. Pflueger and Luis M. Viceira

Abstract

Estimating the liquidity differential between inflation-indexed and nominal bond yields, we separately test for time-varying real rate risk premia, inflation risk premia, and liquidity premia in U.S. and U.K. bond markets. We find strong, model independent evidence that real rate risk premia and inflation risk premia contribute to nominal bond excess return predictability to quantitatively similar degrees. The estimated liquidity premium between U.S. inflation-indexed and nominal yields is systematic, ranges from 30 bps in 2005 to over 150 bps during 2008-2009, and contributes to return predictability in inflation-indexed bonds. We find no evidence that bond supply shocks generate return predictability.

Keywords: Expectations Hypothesis; term structure; Real interest rate risk; Inflation risk; Inflation-Indexed Bonds; Financial Crisis; Inflation and Deflation; Financial Liquidity; Bonds; Investment Return; Risk and Uncertainty; United Kingdom; United States;

Citation:

Pflueger, Carolin E., and Luis M. Viceira. "Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity." Harvard Business School Working Paper, No. 11-094, March 2011. (Revised September 2013.)