Speculation, Sentiment, and Interest Rates

We compare the implications of speculation versus hedging channels for bond markets in heterogeneous agents’ economies. Treasuries command a significant risk premium when optimistic agents speculate by leveraging their positions using bonds. Disagreement drives wedge between marginal agent econometrician beliefs (sentiment). When speculative demands dominate, interaction belief heterogeneity and sentiment helps rationalize several puzzling characteristics Treasury markets. Empirically, we test model predictions find that larger disagreement (i) lowers risk-free rate, (ii) raises slope yield curve, (iii) with positive increases premia makes its dynamics countercyclical. This paper was accepted Karl Diether, finance.