Predictability of Treasury Bond Returns : Risk Premia or Overreaction?

We examine whether the predictability and business-cycle dependence of excess returns in US Treasuries can be more naturally explained in terms of state-dependent risk premia or a specific cognitive bias (representativeness). We show that the extremely parsimonious cognitive-bias model in Shleifer and Gennaioli (2018) accounts very well for a large number of stylized facts about the predictability of excess returns, and their business-cycle dependence. We also test the risk-premium explanation by looking at the correlation between the payoff of the carry strategy and (several proxies for) consumption. When we do so we find that this correlation either has no explanatory power for returns, or has the wrong sign. We conclude that undue extrapolation in the future of recent information provides a parsimonious, simple and arguably more compelling account of excess returns than a risk-premium explanation