On the Inflation Risks Embedded in Sovereign Bond Yields: A Revisit

We revisit the concept of the cost of hedging inflation risks put forward in Bodie (1976). When doing so, we employ a time-varying vector autoregressive model to describe the dynamics of asset returns. We estimate this model by means of the kernel-based methods discussed in Giraitis et al. (2018), but relying on the estimation approach put forward in Morf et al. (1978), which enforces the stability of the estimated VAR. Our modelling framework allows to disentangle the time-varying compensation for expected and unexpected inflation shocks embedded in the sovereign bond yields of Germany, France, Japan and the United States. Our empirical results suggest that the current environment of very low nominal sovereign bond yields, is a reflection of a low real risk-free rate, low inflation expectations and a low cost for hedging inflation risks. We have not encountered similar past episodes in the sample under study. We have tentatively searched for a similar pattern in episodes characterised by recessionary phases of the business cycle coupled with low inflation expectations. However, we failed to robustly associate those episodes with either low real risk-free rates, or with low costs for hedging inflation risks.