How are financial markets pricing the monetary policy outlook? We use surveys to decompose excess returns on money market instruments into expectation errors and term premia. Excess returns are primarily driven by expectation errors, whereas term premia are negligible. Investors face challenges when learning about the Federal Reserve’s response to large, but infrequent, negative shocks in real-time. Rather than reflecting risk compensation, excess returns stem from investors underestimating how much the central bank eases policy in response to such rare shocks. We show, for the US and internationally, that expectation errors imply excess return predictability from past stock returns.

To understand deviations from covered interest parity (CIP), it is crucial to account for heterogeneity in funding costs across both banks and currency areas. For most market participants, the no-arbitrage relation holds fairly well when implemented using marginal funding costs and risk-free investment instruments. However, a few high-rated banks do enjoy CIP-arbitrage opportunities. Dealers avert inventory imbalances stemming from lower-rated banks’ usage of FX swaps to obtain dollar funding by inducing opposite (arbitrage) flows from high-rated banks. Arbitrage trades are difficult to scale, however, because funding costs increase as soon as arbitrageurs increase positions.