THE PURPOSE OF THIS CHAPTER

The discussion about risk factors presented in the previous chapter may have seemed a bit abstract. In this chapter we therefore put some empirical flesh on the theoretical bones.We do so by looking in some detail at the US yield curve after the Great Recession, and in the summer of 2013 in particular. The reason for doing so is that what happened in this period gives a clear illustration of ‘risk factors in action’.

In Chapter 4 we argued that expectations about inflation and real rates, and the attending risk factors, are in principle all embedded in the observed bond yields. Can we say something more precise? For instance, are investors currently reaping a greater compensation for bearing inflation risk, or real-rate risk? Has the ratio of the inflation-to-real-rate risk compensation changed over time?

To answer these questions we examine the joint evidence coming from recent changes in prices of nominal and real Treasury bonds. We will draw the conclusion that, in the twenty-first century, real rates and real-rate risk premia have been the main drivers of yield curve changes. (This may not have been the case in periods such as the 1970s when inflation was a major concern, but, unfortunately, we do not have real-bond data for that period to test this hypothesis.)

EXPECTATIONS AND RISK PREMIA DURING AN IMPORTANT MARKET PERIOD

An Account of What Happened

Economics and finance are plagued by the fact that controlled and repeatable experiments are hardly, if ever, possible. Fortunately, sometimes market conditions and external events occur in combinations not too dissimilar from what a keen experimentalist would have set up if she had been allowed to play God. If we want to understand the interplay between expectations and risk premia (both for real and for nominal rates), the summer of 2013 provided one of these rare ‘real-life laboratory experiments’.

To understand why, let's begin by looking at Figure 5.1, which shows the 10- year, 5-year and 2-year Treasury yields. The first (rather obvious) observation is that, as a response to monetary actions in the wake of the Great Recession of 2007–2009, all these nominal Treasury yields came down (bonds became more expensive) very significantly from late 2009 until early summer of 2013.