Working Paper: Revolving Expectations

Understanding the behaviour of bond markets and the yield curve.

Brad Holland und Robert Köck

Abstract: The problem of term structure is one of uncertainty. No commonly accepted solution has been found to basic questions about the yield curve; what causes it to be the way it is? How can we measure, analyse, and interpret it? The financial market generally falls back on a body of theory that is both old and difficult to align with actual behaviour of bond yields across a variety of maturities. This paper demonstrates the theoretical, intuitive, and empirical difficulties with the most widely accepted theory of term structure – the Local Expectations Hypothesis – and proposes a way around these difficulties. Using simple empirical evidence, and a taxonomy that bridges the gap between the parallel monetary policy and bond cycles, this paper shows that the market is sometimes expectational, and sometimes not.

If the market is not embedding expectations into prices and yields, then traders will be unable to properly price options; central bankers will be unable to understand – and properly influence - market expectations; and bond analysts will be unable to properly know what the bond “market” has “priced-in”. The “Revolving Local Expectations Hypothesis” is put forward as an advancement in our understanding of bond market behaviour. It asserts that markets show themselves to be expectational in some phases and not in others. Knowledge of when a market has entered and left an “expectational” phase is, therefore, extremely important knowledge. The taxonomy proposed in this paper helps determine this.

Datum Titel
September 2003 Revolving Expectations [259 KB]