Can Representativeness Explain the Predictability of Treasury Bonds Returns?

Abstract

This article shows that virtually all the empirical features associated with the predictability of conditional and unconditional excess returns in Treasuries (USD and EUR) can be simply and convincingly explained by an extremely parsimonious model of the joint actions of rational monetary authorities and cognitively biased (“overrepresentative”) investors. With their model, the authors explain and recover, at a quantitative level, the Sharpe ratios of conditional and unconditional strategies, the business-cycle dependence of the profitability of these strategies, the predictability afforded by inflation surprises, the periodicities of the Cieslak-Povala cycles, the patterns of the Cochrane-Piazzesi return-predicting factors, and the term structure of correlation between EH-predicted and realized yield changes. They argue that the explanation for return predictability in Treasuries they offer is simpler than, and at least as empirically compelling as, the more traditional asset-pricing-based explanations.