Good and Bad Macroeconomic Uncertainty: Implications for Bond Risk Premia

Abstract: This paper explores the predictive power of macroeconomic uncertainty on bond risk premia. We decompose quarterly survey data into good and bad uncertainty components by estimating positive and negative semi-variances. Building on theoretical evidence, these uncertainties are assumed to feed into future positive and negative shocks to consumption. In line with our predictions, we find that good (bad) macroeconomic uncertainty predicts a decrease (increase) in future excess returns as well as an increase (decrease) in future economic activity. In addition to this, we document that in the cross section, good (bad) uncertainty contributes positively (negatively) to risk premia, indicating that bonds indeed have high payoffs in bad states of the world and that agents pay a premium for this insurance. Further, we find that our measures of uncertainty add new information not contained in the yield curve and that they are robust once controlled for other sources of macroeconomic uncertainty. Taken together, we present a new characterization and potential explanation of the previously documented countercyclical component in bond risk premia. We also strengthen the view that decomposition of uncertainty provide additional predictive value compared to measures of aggregate uncertainty.