Economic Policy Uncertainty and the Yield Curve

July 30, 2022

Economic Policy Uncertainty and the Yield Curve
Markus Leippold, Felix Matthys
Review of Finance, Volume 26, Issue 4, July 2022, Pages 751–797, https://doi.org/10.1093/rof/rfac031

Financial markets respond both acutely and swiftly to unanticipated political events. In times of elevated political uncertainty, safe assets such as government bonds are in high demand by investors. It is well known that such a flight-to-safety behavior pushes up bond prices, thereby lowering their yields. However, it is not apparent how political uncertainty affects other financial variables such as yield volatility, expectations of future short rates, and the term and bond risk premia. In our work, we not only aim to investigate how policy uncertainty shocks affect these financial variables empirically, but also we want to reconcile these responses through the lens of a theoretical model. To this end, we develop a general equilibrium model which contains both a real and a nominal sector and is populated by an uncertainty-averse agent. While the central bank controls the money supply based on a Taylor rule, the government influences the real sector of the economy using a set of different policy instruments. To introduce economic policy uncertainty, we let the representative agent form her expectation about what policy the government will select. The discrepancy between her expectation and the implemented policy constitutes our measure of policy uncertainty.

Traditional term structure models struggle to replicate the stylized empirical features of bond returns. Our model is up to this challenge. In particular, we can generate a positive bond risk premium under a pro-cyclical short rate. Moreover, in our model, bond risk premia can switch sign. Two mechanisms create this flexibility. First, the agent’s uncertainty aversion generates positive bond risk premia in the long run. Second, the active role of the central bank simultaneously produces a negative bond risk premium at short maturities and a pro-cyclical short rate, which neither long-run risk models nor models with uncertainty averse agents can accomplish. In addition to replicating several features of bond risk premia, our model also fits the level and shape of the term structure of yields and volatilities. We find that the shape of the observed yield volatility curve is crucially impacted by policy uncertainty, which plays a decisive role in explaining why the yield volatility curve is hump-shaped. In addition, we find that expectations about future interest rates are strongly affected by policy uncertainty shocks. Again, our model can give an intuitive explanation for this finding. Since our representative investor is uncertainty-averse, elevated levels of policy uncertainty make her believe that economic growth prospects are worse going forward, which are fundamental to the agent’s consumption and investment allocation decisions. Thus, in equilibrium, lower economic growth in conjunction with an active central bank will cause short rates to fall when policy uncertainty rises.