Predictive power of the sentiment of the Monetary Policy Council

Consensus models assume that the return on capital is set by a constant, psychologically determined, discount rate. The evidence is against this. The stationarity of equity returns and its absence from returns on total capital require a wide variation in either interest rates or leverage. As real interest rates fluctuate over time within a narrow range, the cause of major divergence between the returns on equity and total capital lies in variations in leverage, matched by those in household portfolio preference. Leverage varies and its fluctuations are not offset by changes in interest rates. The return on bonds is not, as consensus models imply, positively correlated with those on equity. Because the return on equity is inelastic to changes in bond yields and leverage is not, the process of adjustment only involves small changes in long bond yields and none in the return on equity. The large difference in bond and equity returns results from the utility function of savers being determined by their prime aim which is to preserve consumption in retirement, contrary to the usual assumption that savings are driven by a wish to boost spending. Retirement savings dominate the household sector’s total financial assets.

This paper studies comovement between changes in sovereign bond yields and stock market returns for ten Eurozone countries (Austria, Belgium, Finland, France, Ireland, Italy, Germany, Netherlands, Portugal, and Spain) in the period from January 2000 – end of August 2011, applying the maximal overlap discrete wavelet transform (MODWT) variance and correlation tools. We found that the for all but one country (namely Portugal) the stock return volatility is higher than the volatility of sovereign bond yield changes across all wavelet scales. The highest volatility in stock indices’ returns and bond yield changes is captured by lower level MODWT wavelet coefficients (i.e., level 1 ( ) MODWT wavelet coefficients, associated with dynamics over 2 to 4 days and level 2 ( ) MODWT wavelet coefficients associated with dynamics over 4 to 8 days). A practical implication stemming from this finding is that investors with short investment horizons that want to efficiently manage the risk of their portfolio investments have to respond to every fluctuation in realized returns or bond yield changes, while for an investor with a much longer horizon, the need to do this is reduces, as long-run risk is significantly smaller as indicated by the variance. The results of the paper show also that the estimated wavelet correlation changes with the time scale and is mostly positive for all countries but Portugal. The statistical evidence against hypothesis of no multiscale dependence yet is weak. Thus we cannot statistically claim that the wavelet coefficients at higher scales are significantly different (either higher or lower) that those at lower scales. For the financial markets of Portugal and Germany we proved that the dependence between stock and sovereign bond market dynamics may not be just a multiscale phenomenon, but may also exhibits time dynamics across scales. The rolling-window wavelet correlation estimates show that at all scales correlation turned negative for Portugal at the start of 2010 – this is when the Eurozone debt crisis started which also hit hard the Portugal sovereign bond market – thus probably causing the ˝average˝ wavelet correlation for Portugal for the whole observed period to be negative. DOI: http://dx.doi.org/10.5755/j01.ee.26.2.6416

The impact of EMU on bond yield convergence: Evidence from a time-varying dynamic factor model

U.S. macroeconomic news and low-frequency changes in bond yields in Canada, Sweden and the U.K.

In an economy in which there are only two sectors, corporations and households, the ratio of debt to equity must be the same in both. If households wish to hold more debt, companies must become more leveraged. Because there are large differences in price elasticities the adjustment occurs through changes in bond yields, rather than in equity returns. Corporate leverage is endogenous and equilibrium is achieved, when fiscal policy and portfolio preference alter, by its response to them via changes in bond yields. Fiscal deficits vary with the cycle, but the possibility of different secular levels rests on the assumption that the economy has more than one possible equilibrium. This is implied by the neoclassical consensus though, due to its failure to recognize the need for the balance between portfolio preference and leverage, there is no analysis on whether the output of economies operating under these different equilibria will grow at different rates. The model explains how this balance is achieved and indicates that an economy with a fiscal deficit and higher interest rates will tend to grow more slowly than one with smaller deficits and lower long-term interest rates.

Ex post corporate leverage must match ex post household portfolio preference. The utility preferences of managers determine the investment, leverage, and pay-out policies of quoted companies, which dominate the economy. Managements seek to maximize the present value of their companies as measured by the stock market not net worth. They avoid being over or underleveraged so that the ratio of interest payments to pre-tax profits is mean reverting. They invest when expected returns match the hurdle rate of 6.7 per cent p.a. The stationarity of equity returns is shown by historic returns and their negative serial correlation. Households dislike falls in income more than they like rises; their utility function leads to a low risk-free rate of interest even for twenty-year bonds and a high return on equity. The utility functions of savers and corporate managers differ, companies do not behave as if they were run by owners. The high elasticity of corporate leverage to changes in bond yields and the low elasticity of household portfolio preference results in their ex post identity being achieved solely through changes in bond yields. The real return on equity is stationary despite changes in demography. There are four constants. The mean reversion of the real return on equity at circa 6.7 per cent. The mean reversion of the profit (after depreciation) and labour shares of output. The mean reversion of the ratio of interest payments to profits. The mean reversion of the ratio of the value of fixed produced capital to output.

PurposeThis study contributes to the pool of knowledge about the impact of monetary policy communication of central banks on financial instruments' prices and assets' value in emerging markets.Design/methodology/approachEmpirical analysis is executed using the National Bank of Poland (NBP) announcements about its monetary policy covering the data from the broad financial market in its three main segments: stock market, foreign exchange market and bonds market. The reactions are measured relative to the changes in the NBP announcements and also with respect to investors' expectations. Autoregressive conditional heteroscedasticity (ARCH) models with dummy variables are used as the main methodological tool.FindingsBonds market and foreign exchange market are the most sensitive market segments, while interest rate and money supply are the most influential types of announcements. The changes of the revealed new macroeconomic figures had more impact on assets' prices movements than the deviations from their expectations. Moreover, greater diversity of the Monetary Policy Council (MPC) members' opinions on the voted motions, captured in the MPC voting reports, is associated with more cases of statistically significant NBP communication events.Practical implicationsThe findings have direct relevance for fund managers, portfolio analysts, investors and also for financial market regulators.Originality/valueThe results provide novel evidence about how the emerging financial market responds to monetary policy announcements. They help understand the nature of the impact of public information on financial assets' valuation and on movements of their prices, analysed comprehensively in three market segments, in the emerging market environment.

Using Merton’s (1974) structural model corporate debt default, this paper argues that correlation between firm level corporate bond yield changes and stock returns should be informative about firm level default risk of this corporate debt. In particular, as the absolute value of the correlation increases, Merton’s framework suggests that default risk increases. We estimate the contemporaneous correlation between firm level corporate bond yield changes and stock returns using daily data, and investigate how this variable sheds light on firm level default risk, as measured by distance to default. We find evidence that as the stock-bond correlations increase in absolute value, the default risks of bonds increase, as expected. In addition, we examine if changes in the stock-bond correlation and the probability of future credit rating changes are related. We find that as the stock-bond correlation increases in absolute value, the probability of credit rating downgrades increases, which is consistent with the finding that the stock-bond correlation is a proxy for default risk.

We document the effects of investor preferences for bonds with particular characteristics on their yields. Using a unique security-level dataset on institutional investors’ monthly holdings of Government of Canada bonds, we study the relationship between the net purchases of investors with different investment mandates and bond yield changes. We find considerable heterogeneity in the impact of net purchases and yield changes, depending both on the type of investor and on the duration of the bond. This provides support for the notion that different segments of the bond maturity spectrum are “inhabited” by particular types of investors and that their investment mandates partly determine the nature of the interaction between their purchases and yields.

This paper examines the policy rate recommendations of the Bank of Canada’s Governing Council (GC) and the C.D. Howe Institute’s (CDHI) Monetary Policy Council (MPC) since 2003. We find, first, that differences in the median recommendations between the MPC and the GC are persistent but small (i.e., 25 bps). The median MPC recommendation is based on a higher steady state real interest rate. However, the response of the MPC and the GC to output and inflation shocks are, for the most part, comparable. Second, we are also able to examine the individual recommendations for the MPC. Estimates of the determinants of consensus inside the MPC or disagreement with the GC yield some useful insights. For example, disagreements are more likely when rates are proposed to rise than at other times. Equally interesting is the finding that the Bank of Canada conditional commitment on the overnight rate in 2009-10 has a relatively larger restricting impact on the MPC’s median recommendation than the GC’s target rate.

This paper examines the policy rate recommendations of the Bank of Canada’s Governing Council (GC) and the C.D. Howe Institute’s Monetary Policy Council (MPC) since 2003. We find, first, that differences in the median recommendations between the MPC and the GC are persistent but small (i.e., 25 bps). The median MPC recommendation is based on a higher steady state real interest rate. However, the response of the MPC and the GC to output and inflation shocks are, for the most part, comparable. Second, we are also able to examine the individual recommendations for the MPC. Estimates of the determinants of consensus inside the MPC or disagreement with the GC yield some useful insights. For example, disagreements are more likely when rates are proposed to rise than at other times. Equally interesting is the finding that the Bank of Canada conditional commitment on the overnight rate in 2009-10 has a relatively larger restricting impact on the MPC’s median recommendation than the GC’s target rate.

The Interest Rate Parity Theorem: A Reinterpretation

Following the collapse of Lehman Brothers in 2008, the Federal Reserve and the Bank of England implemented asset purchase programs to provide further liquidity to faltering markets, and to continue to place downward pressure on market interest rates. Later called Quantitative Easing, the higher asset prices and lower market yields induced by the purchases were expected to translate into lower market borrowing costs and increased investment. This project focused on estimating the effect of Quantitative Easing on real investment in the US and UK up to 2010. First, the historical relationship between bond yields and investment was estimated using a time series econometric model called a structural vector autoregression. Next, using the historical relationship between bond yields and investment, the impact of the asset purchases on investment was calculated using the bond yield changes induced by Quantitative Easing announcements. Deviations in bond yields on Quantitative Easing announcement dates suggested an impact on investment of 5.93% in the US, and an impact of 3.37% in the UK. Moreover, both the US and UK econometric results are statistically significant. Taking into account the econometric assumptions required to estimate the impact of Quantitative Easing on investment, the results in this project should be viewed with caution. However, the results will be useful in framing future thought on Quantitative Easing as a tool to provide macroeconomic stability

This paper explores the sensitivity of Romanian collective investment undertakings’ returns to changes in equity, fixed income and foreign exchange market returns. We use a sample of 80 open-end investment funds and pension funds with daily returns between 2016 and 2018. Our methodology consists of measuring changes in the daily conditional volatility for the fund returns (EGARCH) and changes in their conditional correlation with selected market risk factors (DCC MV-GARCH) throughout different volatility regimes identified using a Markov Regime Switching model. We argue that, on average, the level of conditional correlations between funds and market risk factors remained stable and unconcerned by the volatility regimes. In addition, for only less than half of the funds in the sample, their volatility regimes were synchronized with those of the selected market risk factors. We found that, on average, fund returns are more correlated with equity returns and less correlated with changes in local bond yields, while not being significantly influenced by changes in foreign bond yields or changes in foreign exchange. During the period investigated equity returns were the most volatile while the funds returns volatility were, on average, much more reduced. Overall, our results show the resilience of the Romanian collective investment sector to the selected market risk factors, during the investigated period.

This article develops and empirically implements an arbitrage-free, dynamic term structure model with “priced” factor and regime-shift risks. The risk factors are assumed to follow a discrete-time Gaussian process, and regime shifts are governed by a discrete-time Markov process with state-dependent transition probabilities. This model gives closed-form solutions for zero-coupon bond prices, an analytic representation of the likelihood function for bond yields, and a natural decomposition of expected excess returns to components corresponding to regime-shift and factor risks. Using monthly data on U.S. Treasury zero-coupon bond yields, we show a critical role of priced, state-dependent regime-shift risks in capturing the time variations in expected excess returns, and document notable differences in the behaviors of the factor risk component of the expected returns across high and low volatility regimes. Additionally, the state dependence of the regime-switching probabilities is shown to capture an interesting asymmetry in the cyclical behavior of interest rates. The shapes of the term structure of volatility of bond yield changes are also very different across regimes, with the well-known hump being largely a low-volatility regime phenomenon.