Which of the following financial assets is likely to offer the most effective hedge against bad consumption outcomes?
Equities
Short-dated, default-free government bonds
Long-dated, default-free government bonds
Why short term bonds, why not long term?
In the broadest sense, the longer-dated portion of the interest rate curve will reflect expectations for the long-term rate of inflation, while the shorter-dated potion will reflect expectations for short-term interest rate dynamics. The shorter-term portion of the curve tends to be more volatile in that short-term rates typically are more reactive to macro prints and newsflow.
A bad consumption print may increase the perceived likelihood of a short-term monetary policy response (i.e. rate cut) should it be seen as necessary to stimulate the economy. If you are long short-dated government bonds and market interest rates fall the value of your position will increase. While the print may also have an impact on longer-dated bonds, it’s likely that the effect will be more muted as more likely than not the effect on the economy will be for the most part transitory - economic prints hit and miss expectations all the time (as an aside the impact on equity markets - and futures - can be quite fun to trade). A singular miss is unlikely to have any meaningful impact on the expectations for the long-term inflation rate; a persistent downward trend is a different story in this regard.
Hopefully that helps.
Thanks…This helps…I was thinking from the perspective that LT bonds give higher returns, hence they would be a better hedge.
Ok, pls tell me one more thing - Will inter-temporal rate of substitution be always less than 1?