Nominal U.S. Treasuries Embed Liquidity Premiums, Too

J. Benson Durham

♦ A novel arbitrage-free model of nominal U.S. Treasuries that decomposes yields into frictionless expected rates, frictionless term premiums, and liquidity premiums produces four key results from January 1987 through August 2023. First, liquidity loadings are larger than for the slope and higher order principal components. Second, counter-cyclicality of required nominal Treasury returns owes to liquidity, if anything, not frictionless term premiums. Third, Federal Reserve large-scale asset purchases generally work through expected rates and frictionless term premiums, not liquidity premiums. Fourth, given similar estimates using TIPS, inflation expectations are less moored around the Federal Reserve’s price objectives than other models say.

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