The Fed began producing its ‘dot plot’ (otherwise known as ‘the blue dots’) in January 2012 to give clear guidance to the market of where the members of the Monetary Committee saw the more likely value for the Fed funds at different horizons in the future.
For short horizons, it is not too surprising that these projections may change, as information about the speed of the recovery, inflationary pressures, unemployment and other macrofinancial variables is progressively revised.
The ‘last blue dot’ should be different. This last point represents the projection over the ‘very long run’ of the most likely level for the Fed Funds – as made by the very people in charge to set the rate! Barring truly secular in nature, this quantity should be very stable, as it reflects a combination of expectations about long-term inflationary pressures and real growth in the economy.
In reality, as Fig 1 shows, it has been anything but. When the Fed began communicating its monetary intentions via the dot plot (as recently as January 2012, ie, almost exactly 8 years ago), it expected the Fed funds in the distant future to be as high as 4.12%. At the last Committee meeting, the same long-term expectation of the Fed funds was 2.54%: more than 150 basis points lower.
At every single meeting, the expectation has either remained unchanged, or has drifted lower. It has done so by changing (always downwards) far more than the dispersion of opinions (which has a very stable standard deviation of about 30 basis points) would justify. What has been happening?
Make no mistake: when monetary economists predict a future nominal ‘short rate’ as low as 2.50%, they must either believe that the Fed will not be able to prevent a collapse in inflation (which can only be associated with difficult economic conditions); or that the real rate of growth will be extremely low; or both. A far cry from what the equity valuations seem to imply at the moment. Either the economists or the S&P500 must be wrong.
With such a dramatic fall in expectations, one could be forgiven for expecting that risk premia should have widened. After all, the nominal yield that we see should be the sum of expectations (that have fallen) and risk premia. Hardly so. The 10-year nominal yield, as of this writing, is around 160 basis points. Suppose that the expected inflation is 2.00% (below the official target), and that there is no compensation for inflation risk. The sum of the real rate and the real-rate risk premium is therefore around minus 50 basis points. Even a rather gloomy projection for 10-year real growth of 1% forces the risk premium to be a negative -150 basis points. How can this make sense?
The only way to rationalize this extremely low value is to remember that a positive risk premium is compensation for being paid well in good states of the world, and poorly when you would need the money. Conversely, a negative risk premium attaches to assets that pay well when you feel poor, and vice versa. As we move beyond 10 years of almost uninterrupted rise in the equity market, the value of the ‘Greenspan (now Powell) put’ is becoming more and more keenly felt. If you add in the complications of an election year, and a US President who is happy to lean on the Chairman of the Fed as robustly as few Presidents have done in recent memory, and it is easy to see that the market is betting the farm on the Fed cavalry coming to the rescue at the next serious bump in the road.
If looked at in this light, the 150 basis points of negative risk compensation are the risk premium investors seem to be willing to pay to offset their equity risk. For this to be a ‘good insurance price’, the Treasury hedge has to work close to perfection. The room for error that current yield levels leave is extremely thin.
EDHEC is launching the EDHEC Bond Risk Premium Monitor in September 2017. Its purpose is to offer to the investment and academic community a tool to quantify and analyse the risk premium associated with Government bonds (with an initial focus on US Treasuries).
The following FAQs provide detailed explanations of what it can offer.
For a precise definition, see Cochrane (2001), Asset Pricing, Princeton University Press, or Rebonato (2018), Bond Pricing and Yield Curve Modelling – A Structural Approach, Cambridge University Press, Chapter 15.
In the case of (riskless) bonds, the risk premium is associated with the strategy of being ‘long duration’, (i.e. of funding a long position in a long-maturity bond by shorting a short-maturity bond). The strategy is often referred to as a ‘carry’ trade.
Risk premia provide timing (rather than cross-sectional) investment information. They answer the question, “Is today a good (bad) time to be long duration?” They do not answer the question, “Given that I have to be invested today, which bond gives the most attractive expected return?”
Risk premia also allow the market expectations about the future path of the short rate (Fed funds) to be extracted from the market yields.
We stress that changes in risk premia are more reliably estimated than the level of risk premia (the ‘slopes’ of the regressions have tighter confidence bands than the ‘intercepts’).
We also present the average of the four predictions, which is arguably the most reliable estimator.
(I) Strictly speaking, one should also take convexity into account. For a discussion, please refer to Rebonato (2018). Bond Pricing and Yield-Curve Modelling – A Structural Approach, Cambridge University Press, Chapters 20-21.
(II) See Rebonato (2018). Bond Pricing and Yield-Curve Modelling – A Structural Approach, Cambridge University Press, Chapter 24.
(III) See Cochrane, J. H. and M. Piazzesi (2005). Bond Risk Premia. American Economic Review 95(1): 138-160; for technical details, and the regression coefficients, see https://www.aeaweb.org/aer/data/mar05_app_cochrane.pdf (accessed on 25 November 2014).
(IV) Cieslak, A. and P. Povala (2010a). Understanding Bond Risk Premia. Working paper – Kellogg School of Management and University of Lugano, available at
https://www.gsb.stanford.edu/sites/default/files/documents/fin_01_11_Cie..., accessed on 5 May 2015, and Cieslak, A. and P. Povala (2010b). Expected Returns in Treasury Bonds, working paper, Northwestern University and Birbeck College, forthcoming in Review of Financial Studies.
(VI) Hatano, T. (2016). Investigation of Cyclical and Unconditional Excess Return Predicting Factors. MSc thesis – Oxford University.
(VII) See Rebonato (2018). Bond Pricing and Yield-Curve Modelling – A Structural Approach, Cambridge University Press, Chapter 25 for a discussion of this point.
(VIII) For a chapter-length description of affine models, see, Piazzesi M. (2010), Affine Term Structure Models, Chapter 12 in Handbook of Financial Econometrics, Elsevier, or Bolder, D. J. (2001). Affine Term-Structure Models: Theory and Implementation, Bank of Canada, Working paper 2001-15, available at http://www.bankofcanada.ca/wp-content/uploads/2010/02/wp01-15a.pdf , accessed on 11 August 2017. For a book-length treatment, see Rebonato (2018), Bond Pricing and Yield-Curve Modelling – A Structural Approach, Cambridge University Press.
(IX) For a detailed description of the model, see Rebonato (2017). Reduced-Form Affine Models with Stochastic Market Price of Risk, International Journal of Theoretical and Applied Finance(forthcoming).
In this paper we discuss the common shortcomings of a large class of essentially-affine models in the current monetary environment of repressed rates, and we present a class of reduced-form stochastic-market-risk affine models that can overcome these problems. In
particular, we look at the extension of a popular doubly-mean-reverting Vasicek model, but the idea can be applied to all essentially-affine models.
Read more »
By accessing this tab via the website, users signal their agreement with the conditions and clauses set out below and pledge to abide by them.
The purpose of these sections is to showcase and present academic research only. It seeks to provide information concerning non-investable indices and a database that may be used for research purposes. None of the information may be considered as constituting an offer of products or services, particularly of financial products, on the part of EDHEC-Risk Institute, nor as a solicitation to purchase or sell securities or any other investment product.
EDHEC-Risk Institute does not offer any online services, nor any benefits and makes no pledge whatsoever to maintain the continuity of its research production.
EDHEC-Risk Institute reserves the right to amend these conditions at any moment without notice, with publication of the new conditions being deemed to constitute notification to users and indicate their consent.
The general structure of this website, as well as the texts, graphics, images, sounds and videos that comprise it, are the property of EDHEC-Risk Institute. Any representation and/or reproduction and/or exploitation of the content and services proposed by Investment Solutions, either partially or in full, by any process whatsoever, without prior written authorisation from EDHEC-Risk Institute is strictly forbidden and liable to constitute an infringement of articles L 335-2 et seq. of France’s Intellectual Property Code (Code de la propriété intellectuelle).
Any representation and/or reproduction and/or exploitation of EDHEC-Risk Institute’s trademarks, either partially or in full, in any manner whatsoever, is totally prohibited.
This website is designed for personal ends and not for commercial purposes.
EDHEC-Risk Institute may in no case be held liable for any form of direct or indirect loss, nor any other prejudice in any form whatsoever, resulting from the use of this section or the impossibility of using it for any reason whatsoever, whether such liability is or is not contractual, tortious or quasi-tortious or if founded on the principle of liability without fault or other, and even in the event that EDHEC-Risk Institute may have been warned of the eventuality of such loss or prejudice.
-EDHEC-Risk Institute may not be held liable for the use of the information available in this website; EDHEC-Risk Institute does not guarantee that the information is free from error; consequently, any use that users make of the information is done so at their own risk;
-none of the elements contained on the site constitute asset allocation advice, financial or investment advice or advice of any other nature;
-none of the indices on this site shall be used or referenced as a benchmark by any financial instrument, financial contract or investment fund where such use or reference falls within the scope of Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014 and EDHEC-Risk Institute shall not be responsible for any such use or reference.
-the projections presented are based on simulations; past performances in no way guarantee future performances. The information provided may in no way be deemed to represent investment guarantees or investment-return guarantees.
This list is not limitative.
This tab may contain hypertext links to other sites on the internet. The links towards these other resources lead you to exit this site.
These links and sources of information are provided for users purely for informational purposes only. EDHEC-Risk Institute has no authority over the content of characteristics of these other resources and may in no case be held liable for their content or for any loss or prejudice that may result from their use.
Users must take the necessary precautions to ensure that the said resources do not contain any viruses or any other malicious elements.
The user hereby accepts the characteristics and limits of internet, and recognises in particular that:
EDHEC-Risk Institute does not assume any liability for the services accessible by internet and does not exercise any control in any form whatsoever over the type and characteristics of the data that might transit via its server centre.
The user recognises that the data circulating on internet is not protected, particularly against possible misappropriation. Communication of any information deemed by the user to be sensitive or confidential is done so at the user’s own risk and peril.
The user is solely liable for the use of data that he/she consults, searches and transfers on Internet.
The user recognises that EDHEC-Risk Institute does not possess any means of controlling the content of the accessible services
Both this site and its terms and conditions of use are governed by French law, wherever the place of use. In the event of any dispute, and after the failure of all attempts to find an amicable solution, the French courts of Lille shall be the sole ones competent to adjudicate such disputes.