The Impact of Market Sentiment and Macroeconomic Fundamentals on Government Bond (Mis)-pricing

This paper evaluates government bond mispricing through the creation of two indicators. Building on two different government bond fair values, by Favero et al. (2023) and Ceci and Pericoli (2022), mispricing metrics separate the share of sovereign bond yield driven by macroeconomic variables from the one influenced by market sentiment. Misvaluation is measured as the gap between market value and fair value aligned with economic fundamentals. This work examines how fundamental and sentiment indicators influence mispricing and compares these metrics. Additionally, this study elucidates the associations among sentiment factors, mispricings, and real variables by comparing the performances of both measures in describing the effects of bond misvaluation on real GDP growth. Results reveal disparities in the effect of macro variables on the ”idiomatic” and ”fitted” measures. However, during times of increased uncertainty, sentiment variables emerge as the only driver of the theoretical mispricing, meaning that the idiomatic component captures the entire variation driven by fundamentals in the observed yield. Concerning real variables, the idiomatic mispricing positively affects a country’s growth, indicating that periods of favorable rates relative to fundamentals may lead to lower future growth. Therefore, when spread is appropriately priced, it serves as a benchmark for policy decisions. However, in the occurrence of mispricing, policymakers are advised to consider additional indicators.