Term premia and international bond markets

The latest AER published a note on term premia and inflation uncertainty by Bauer, Ruderbush and Wu which confirms some of the basic intuition on bond markets. Their paper is an extension of earlier work by correcting the small sample bias created by looking at a limited time period. They find that term premia decrease with decrease in inflation and growth uncertainty. When we have less risk with our inflation forecasts, we will have less risk in the bond market. This makes simple sense. The reduction in inflation and the more range-bound behavior of inflation forecasts lead to lower premia over the last few years. From a central bank perspective, forward guidance can be particularly effective if it can provide insight on why ill be long-tern inflation and growth. If we can see less risk in these key variables, long-rate premia will come down.

They also find that term premia are counter-cyclical and peak in recession periods. This occurs in all bond markets around the world. There is negative relationship with GDP and with leading indicators. The term premia is positively related to a recession dummy variable.  

The take-away is simple do not mess with the simple dynamics of term premia around the globe. It will create headwinds and tailwinds that can be used effectively.