Bonds, currencies and expectational errors

Eleonora Granziera and Markus Sihvonen

No 7/2020, Bank of Finland Research Discussion Papers from Bank of Finland

Abstract: We propose a model in which sticky expectations concerning shortterm interest rates generate joint predictability patterns in bond and currency markets. Using our calibrated model, we quantify the effect of this channel and find that it largely explains why short rates and yield spreads predict bond and currency returns. The model also creates the downward sloping term structure of carry trade returns documented by Lustig et al. (2019), difficult to replicate in a rational expectations framework. Consistent with the model, we find that variables that predict bond and currency returns also predict surveybased expectational errors concerning interest and FX rates. The model explains why monetary policy induces drift patterns in bond and currency markets and predicts that long-term rates are a better gauge of market's short rate expectations than previously thought.

Keywords: Bond and currency premia; sticky expectations; interestrate forecast errors (search for similar items in EconPapers)
JEL-codes: D84 E43 F31 (search for similar items in EconPapers)
Date: 2020
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Related works:
Journal Article: Bonds, currencies and expectational errors (2024)
Working Paper: Bonds, currencies and expectational errors (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:bofrdp:rdp2020_007

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