Why are excess returns on China's Treasury bonds so predictable? The role of the monetary system

It is well documented that the time-varying bond excess returns can be explained by predetermined variables such as information in the term structure and macro economic variables. Recent studies suggest that demand and supply of bonds influence bond excess returns. We extend the literature and find that monetary system attributes affect return dynamics in the bond market. By introducing a theoretical model to forecast excess returns on Treasury bonds in the context of China's unique monetary system, this paper attributes the predicted components of bond excess returns mainly to the inflexible term structures of official interest rates set by China's central bank.

► We model factors affecting market interest rates and bond excess returns. ► We examine the predictability of excess returns on China's Treasury bonds. ► Monetary system attributes affect return dynamics of bonds. ► Inflexible term structures of official interest rates cause return predictability. ► Monetary system's influence cannot be mitigated by market arbitrage activities.