Working Papers

Is Iran to Blame for the Bond Yield ‘Conundrum’?

Kevin Hassett, drawing on Robert Barro’s work on ‘Rare Events and the Equity Premium,’ asks whether the prospect of a show-down over Iran’s nuclear program might be responsible for low bond yields:

If Barro is right, long-term rates may depend on low- probability geopolitical variables. And the effects may be enormous, perhaps even dwarfing the effects of traditional variables such as the deficit.

Barro clarified this connection in a recent interview: “A small increase in this kind of risk—as an example, due to the Sept. 11th events—leads to a noticeable response in real interest rates. When this probability goes up, the risk-free rate goes down because people put more of a premium on holding a relatively safe asset.”…

there has been a movement that is consistent with the Barro story. Intrade.com offers a futures contract that pays off if the U.S. or Israel bombs Iran between now and the end of March 2007. That probability has soared in recent weeks, and stood at a sobering 31.6 percent on Dec. 30…

Iran, not Iraq, may be the big story of 2006, both politically and economically.

I prefer a monetary policy credibility explanation for low bond yields, but would agree that Iran will loom large this year.

posted on 04 January 2006 by skirchner in Economics

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