Are Treasury Rates too Volatile?

Econbrowser thinks so, in a very nice post here. Please read Dr. Hamilton's comments as they are up to his normal high quality.

I disagreed with his (and the paper he referenced) conclusion however. Here is the comment I left:

I agree that if you assume a model of risk neutral, single decision investors with limited choices, the bond market is more volatile than it should be.

But in reality, Treasury rates reflect various economic elements, only one of which is future inflation. The real Treasury rate is a function of perceived opportunity cost of investing money.

When there are ample profitable investments available, relatively low Treasury rates seem unattractive, driving the real Treasury rate higher. When investment opportunities are scarce, funds flow toward the Treasury market.

This is in part a function of investors changing perception of risk. For example, when default risk is perceived to be low, investors may choose to own high-risk junk bonds and eschew Treasury bonds. But when default risk is perceived to be high, the opposite will happen. Or if prospects for the stock market are perceived to be strong, low Treasury yields seem inadequate. Etc. etc.

The varying view of risk and opportunities world wide alters every day. So for the yield on the 10-year Treasury to move 5-10bps on a given day suddenly doesn't seem so surprising.

Furthermore, a large percentage of bond holders do not hold bonds for profit. Many are holding for hedging or asset-liability purposes. This alters demand for rates product. Hedgers particularly can cause movement in rates to accelerate.

I'd be easy to say this is a case of academia not understanding reality, but it isn't that. I think here we have a model which produces less volatility than is observed, but that is only because the base assumptions eliminate many of the reasons for the volatility. I think it would be possible to create a model which could indeed account for market volatility.