Inflation Risk and Yield Spread Changes

Inflation risk explains more than 40% of the systematic variation of yield spread changes beyond standard structural factors. I show that changes in expected inflation, volatility, and cyclicality are significant determinants of yield spread changes. A structural model with a stochastic price index and sticky cash flow accounts for these patterns and delivers further implications. In the cross-section, the model predicts increasing loading patterns on leverage and cash-flow flexibility. In the time series, the model predicts diminished effects during periods of high expected inflation. I find empirical support for the model’s predictions.