Inflation and the joint bond-FX spanning puzzle
Summary
Focus
We investigate the relationship between inflation and excess returns in bond and foreign exchange (FX) markets, specifically addressing the "spanning puzzle". Standard macro-finance models suggest that yield curve factors should capture all bond and FX predictability, making other variables, such as inflation, irrelevant predictors. In other words, the information in these variables should already be "spanned" by the yield curve itself. However, we challenge this by showing that inflation acts as a common unspanned predictor of both bond and FX returns. We trace the origins of these findings to investors' incomplete information about the central bank's monetary policy rule.
Contribution
Our paper makes three key contributions. First, it generalises the yield spanning condition to non-linear models and exchange rates. Second, it provides novel empirical evidence that inflation is an unspanned predictor of both bond and FX returns, violating the spanning condition. Third, it provides a deep dive into the mechanism behind the result and presents a simple theoretical model to explain the observed deviations, emphasising the role of investors' incomplete understanding of the Federal Reserve's monetary policy rule.
Findings
We document that US inflation predicts both low bond returns and high dollar returns, even after accounting for the information embedded in yield curves. We attribute this finding to unexpected monetary policy tightening in response to high inflation, which leads to dollar appreciation and lower bond returns. We also identify that inflation predicts monetary policy shocks, expectational errors regarding long-term interest rates and revisions in perceived central bank policies. These findings suggest that investors struggle to fully grasp the Federal Reserve's reaction function, leading to predictable patterns in bond and FX markets. The proposed model illustrates how inflation can remain unspanned by yield curve factors, in line with the empirical facts.
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.
JEL Classification: G12, E43, E58
Keywords: inflation, bond markets, exchange rates, central bank reaction function, investor expectations
