Maturity Increasing Overreaction and Bond Market Puzzles

Long-term treasury yields are known to be (i) excessively volatile (Giglio and Kelly

(2018)), (ii) highly sensitive to short rate movements (Hanson et al. (2018)), and (iii)

highly predictable from non-priced factors (Duffee (2013)). I assess the possibility

that these puzzles may be due to non-rational investor beliefs. Using survey data as

well as market beliefs recovered from bond yields, I document that expectations about

long rates overreact to news, relative to expectations about short rates. I show that

introducing diagnostic expectations into an affine term-structure model yields such

maturity increasing overreaction and reconciles the three puzzles. When benchmarked

against external estimates of diagnostic distortions, this model accounts for (i) 80% of

the excess volatility, (ii) 40% of the excess sensitivity of long rates, and (iii) excess-bond-

returns predictability coming from past forecast revisions.

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