Monetary Policy and Bond Prices with Drifting Equilibrium Rates and Diagnostic Expectations

We study drift and cyclical components in Treasury bonds. We find that bond yields are drifting because they reflect the drift in monetary policy rates. Empirically, modeling the monetary policy drift using demographics and productivity trends, plus long-term inflation expectations, leads to stationary cyclical deviations of bond prices from their drift that predict U.S. bond excess returns in- and out-of-sample. These bond cycles can originate from either term premia or temporary deviations from rational expectations in a behavioral framework. Through the lens of our model, we detect a significant role of the latter in determining the cyclical properties of yields.