Economic Policy Uncertainty and Bond Risk Premia

We study the forecasting power of economic uncertainty about government policy for future bond returns. Using the economic policy uncertainty measure (EPU) developed by Baker, Bloom, and Davis (2016), we investigate its relationship to expected bond returns. The impact of the EPU is shown to be large for earlier maturities at shorter investment horizons. Estimating an affine term structure model incorporating the EPU, we show that term premia estimates from this model with this additional pricing factor exhibit higher fluctuations and move closely with the variations in observed yields. The implied term premia show strong countercyclical movements, hence better explaining higher risk compensation under adverse economic conditions as expected by theory.