Bonds, currencies and expectational errors

We propose a model in which sticky expectations concerning short-term interest rates generate joint predictability patterns in bond and currency markets. Our parsimonious specification can explain the downward sloping term structure of carry trade returns, difficult to replicate in a rational expectations framework. We offer empirical support for our approach and show that including a sticky short rate expectations channel into a standard affine term structure allows the model to better capture the drift patterns in the data.

Automated summary

This study proposes a model that explains the joint predictability patterns in bond and currency markets through sticky expectations of short-term interest rates. The results show that including a sticky short rate expectations channel allows the model to better capture the drift patterns in the data and explain the downward sloping term structure of carry trade returns.