Yield Curve Dynamics and Fiscal Policy Shocks

We show that the design of fiscal policy does play a role in shaping the yield curve which has quantitative consequences for the cost of private and government financing. We combine government spending shock identification strategies from the fiscal macro literature with recent advancements in no-arbitrage affine term structure modeling, where we account for time-varying macroeconomic trends in inflation and the equilibrium real interest rate. We stress in our empirical macrofinance framework the importance of timing in the response of yields to government spending. We find that the yield curve responds positively to a surprise in government spending shocks whereas changes in expectations about future expenditures decreases yields across all maturities. Complementarily, we also analyze the effect of fiscal policy uncertainty where higher fiscal uncertainty lowers yields. Pre-announced fiscal policy therefore features lower cost of financing for government