The sensitivity of long-term rates to short-term rates represents a puzzle for standard macro-finance models. Post-FOMC announcement drift in Treasury markets after Fed Funds target changes contributes to the excess sensitivity of long rates. Mutual fund investors respond to the salience of Fed Funds target rate increases by selling short and intermediate duration bond funds, thus gradually increasing the effective supply to be absorbed by arbitrageurs. Using FOMC-induced variation in bond fund flows, we estimate short-run demand for Treasurys to be inelastic, especially for longer maturities. The gradual increase in supply, combined with the low demand elasticity, generate post-announcement drift in Treasurys, which spills over to other bond markets. Our findings shed new light on the causes of time-series-momentum in Treasury markets.
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