A Long-Run Risks Explanation of Predictability Puzzles in Bond and Currency Markets

In the data, we show that bond risk premia increase at times of high uncertainty about expected inflation and decrease with high uncertainty about expected growth; the magnitude of bond return predictability by these two uncertainty measures is similar to that found based on multiple yield factors. Motivated by this evidence, we provide an equilibrium long-run risks model which features time-varying volatilities of expected growth and expected inflation, and non-neutral inflation effect on future growth. We estimate the model and show that it can (i) successfully match the observed bond yield and macroeconomic data, (ii) account for bond return predictability evidence based on real and inflation uncertainties as well as the yield-based projections, and (iii) simultaneously explain for violations of the uncovered interest parity in currency markets. In the model, as in the data, bond risk premia are high in periods of high inflation uncertainty (e.g., 1980s), and are low and even negative in periods of high real uncertainty (e.g., mid-2000). We show that preference for early resolution of uncertainty, time-varying volatilities, and a non-neutral effect of inflation on growth are important to account for these aspects of bond markets.