A Portfolio-Balance Approach to the Nominal Term Structure (Revised, January 2015)
Last Updated: 07/31/13
I examine how the maturity structure of outstanding government liabilities affects the nominal yield curve under a variety of assumptions about investor objectives. In the class of models I consider, equilibria are arbitrage free, expectations are rational, and assets are valued only for their pecuniary returns. Nonetheless, a portfolio-balance mechanism arises through the dependence of the pricing kernel on the return on wealth. This mechanism results in a positive relationship between the duration of bondholders’ portfolios and the price of interest-rate risk. Quantitatively, the models suggest that the effects of shifting Treasury supply on yields can be substantial—for example, the increase in the average maturity of U.S. government debt that occurred between 1976 and 1988 may have raised the ten-year yield by 50 basis points. On the other hand, partly reflecting an attenuation of portfolio-balance effects when interest rates are near zero, the Federal Reserve’s asset purchase programs likely had a fairly small impact on the yield curve by removing duration from the market.