Abstract

I document a robust pattern in how Treasury market participants’ yield curve expectations respond to new information: forecasts for short-term rates underreact to news while forecasts for long-term rates overreact. I propose a new explanation of this based on ``autocorrelation averaging,’’ whereby, due to limited processing capacity, forecasters’ estimate of the autocorrelation of a given process is biased toward the average autocorrelation of all related processes. Consistent with this view, forecasters overestimate the autocorrelation of the less persistent term-premium component of interest rates and underestimate the autocorrelation of the more persistent short-rate component; a calibrated model quantitatively matches the documented pattern of misreaction. Moreover, banks’ allocations to Treasuries vary positively with their expectations of bond returns and misreaction proxies can strongly predict future short- and long-term bond returns, respectively.

Hong Kong University of Science and Technology, Cheung Kong Graduate School of Business, University of Hong Kong, National University of Singapore, Chinese University of Hong Kong, Notre Dame, Michigan Ross, University of Florida, Cornerstone Research, Yale SOM, 2021 WFA