Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds

The covariance between US Treasury bond returns and stock returns has moved considerably over time. While it was slightly positive on average in the period 1953 to 2014, it was unusually high in the early 1980s and negative in the early 21st Century, particularly in the downturns of 2001 and 2007 to 2009. This paper specifies and estimates a model in which the nominal term structure of interest rates is driven by four state variables: the real interest rate, temporary and permanent components of expected inflation, and the nominalreal covariance of inflation and the real interest rate with the real economy. The last of these state variables enables the model to fit the changing covariance of bond and stock returns. In the model, a high nominal-real covariance implies a high term premium and a concave yield curve. The decline in this covariance since the early 1980s has driven down our model-implied term premium on 10-year zero-coupon nominal Treasury bonds by about two percentage points.