Yield curve dynamics and fiscal policy shocks

Abstract

This paper examines how anticipated, unanticipated, and uncertainty shocks in U.S. government spending affect the term structure of interest rates, showing that fiscal policy design significantly influences the yield curve and financing costs. Combining a recursively-identified fiscal SVAR with an affine term-structure model that incorporates five-year Congressional Budget Office projections and the Economic Policy Uncertainty index, we recover three orthogonal fiscal shocks and trace their effects on bond markets and economic activity. We find that heightened fiscal policy uncertainty induces a flight to quality, causing immediate declines in Treasury yields. Unanticipated spending shocks have a limited impact on yields, underscoring the forward-looking nature of financial markets. Anticipated spending shocks also lower yields as investors adjust expectations about future macroeconomic conditions. Contrary to traditional views, we observe a contractionary effect on real GDP growth, as lower yields reinforce precautionary behavior among households and firms. Our macro-finance framework captures the bidirectional relationship between macroeconomic expectations and financial markets, highlighting the critical role of the yield curve in transmitting fiscal policy shocks to the real economy.