Public Debt and the Slope of the Term Structure

The maturity-weighted public debt-to-GDP ratio predicts negatively one- to five-year cumulative nominal consumption growth. Moreover, a higher debt-to-GDP ratio is associated with higher yield spreads, controlling for output gap and inflation. I examine these facts in a New Keynesian DSGE model in which growth and inflation are endogenous. In this model, high government debt forecasts low growth and deflation, making bonds attractive assets in high debt states. Furthermore, due to mean-reversions of fundamental processes that drive the economy, longer-term bonds are better hedges than shorter-term ones, resulting in increases in the slope of the term structure at times of high public debt and hence the empirical regularities seen in the data. My model can also explain several other puzzling phenomena, including the bond premium puzzle, the bond yield volatility puzzle, the failure of the expectations hypothesis, and the ability of a linear combination of the forward rates and the forward spread to forecast excess bond returns.