How Markets Price Risks? Key Insights From an Analysis of the US Treasuries Market

We propose a new model of the US yield curve where expectations for future risk premia on 10-year bonds are considered as hidden latent variables. We extract the history of these key expectations, and we document a fundamental irrationality that has characterized the last 20 years and explain most past “conundrum”. Due to many structural changes, the short-term risk premium on 10-year bonds turned negative as soon as the early 2000s: since that time, investors have been systemically expecting a lower short-term return on 10-year bonds than on T-bills. Yet, and here lays the irrationality, according to our estimates, investors have never changed their view that “normal” risk premia are significantly positive. Quantitative Easing had a strong impact on rates, mainly because it convinced investors to delay the expected timeframe of the return to positive risk premia. But it did not change the (wrong) view that equilibrium risk premia on bonds are necessarily positive. This model highlights an important general phenomenon that is not proper to the bond market. When there is a lasting change in required short-term excess returns over T-Bills, investors often miss the structural or quasi-structural changes in risk premia and base their decisions on a biased valuation methodology. We see this recurrent weakness of the fundamentalist approach as a major source of markets instability