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Inflation and the joint bond-FX spanning puzzle

Author

Listed:
  • Andreas Schrimpf
  • Markus Sihvonen

Abstract

We generalize the yield spanning condition in the bond literature to non-linear models and to exchange rates. In standard macro-finance models, no variable should predict yield or exchange rate changes once standard yield curve factors are controlled for. We provide novel evidence that this spanning condition is violated, with inflation as a common unspanned predictor of both bond and exchange rate returns. Investors' incomplete information about the Federal Reserve's monetary policy rule emerges as the key driver of this result. We find high inflation to be followed by unexpected monetary policy tightening, which leads to dollar appreciation and low bond returns. We explain these findings by a simple model that departs from full information rational expectations.

Suggested Citation

  • Andreas Schrimpf & Markus Sihvonen, 2025. "Inflation and the joint bond-FX spanning puzzle," BIS Working Papers 1320, Bank for International Settlements.
    • Handle: RePEc:bis:biswps:1320
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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