Economic Policy Uncertainty and the Yield Curve

Abstract

We study the impact of economic policy uncertainty on the term structure of nominal interest rates. In a general equilibrium model populated by an uncertainty-averse agent, we show that political uncertainty not only affects the yield curve and the corresponding volatility term structure but also bond risk premia carry a premium for political uncertainty. Our model simultaneously captures both the shape of the yield curve and the hump shape of yield volatilities, a stylized feature that is hard to match with a theoretical model. Our model gives rise to a set of testable predictions for which we find strong support in the data: Higher policy uncertainty leads to a significant decline in yield levels and increases bond yield volatilities. Moreover, policy uncertainty predicts future short rates and has an ambiguous effect on term premia. Finally, short (long) maturity bond risk premia respond negatively (positively) to increases in policy uncertainty.