Abstract
In this paper, we adopt the nonlinear autoregressive distributed lags (NARDL) model extended by Shin et al. (2014) to investigate the relationship between the treasury yield spread and economic policy uncertainty (EPU) in Japan. This model helps us to explore the short- and long-run asymmetric reactions of explained variables through positive and negative partial sum decompositions of changes in the explanatory variable(s). In our research, the testing of the NARDL specification reveals the existence of a significant long-run asymmetric equilibrium between the yield spread and EPU in Japan. On the other hand, we find a significant positive nexus between the treasury yield spread and EPU reduction in the long run. We speculate that because of low inflation, a poor economic outlook and the low interest rate environment since 1990, financial agents are markedly sensitive to negative shocks resulting from EPU. This means that when facing a good economy, bond agents are quick to sell, especially with higher-risk long-term interest rate bonds. Meanwhile, because the Bank of Japan announced the Stock Purchasing Plan in October 2002 and from the point view of portfolio management, while the influence of a positive economic outlook dominates the negative outlook, flight from quality has no role in asset portfolio adjustment. The empirical implications are that the long history of unconventional monetary policy supports the demand for both bonds and stock markets. When taking the stock market into consideration, the correlations between the yield spread, EPU and stock market capture the full wealth effects of the low interest rate environment in Japan.
Highlights
People rely on yield spreads as indicators for forecasting the future state of the economy and the probability of a recession [1,2]
We explore some interesting yet previously untouched questions: (1) Considering the predictive power of economic policy uncertainty (EPU) on the macroeconomic outlook and given its backward-looking and predominantly biased information, what is the influence of negative and positive shocks in EPU on the yield spread and the forecasting actions taken by the financial market agents and the monetary policy authority in Japan? (2) Considering asset portfolios and thereby the wealth effect and asset substitution effect, when EPU suffers positive or negative shocks, what is the adjustment of the yield spreads and asset portfolios?
Based on the nonlinear autoregressive distributed lags (NARDL) method adopted, we successfully explore short- and long-run asymmetric reactions in financial variables and in treasury yield spread, which is markedly sensitive to negative shocks resulting from EPU, while taking the Bank of Japan (BOJ)’s Stock Purchasing Plan in October 2002 into consideration
Summary
People rely on yield spreads as indicators for forecasting the future state of the economy and the probability of a recession [1,2]. We explore some interesting yet previously untouched questions: (1) Considering the predictive power of EPU on the macroeconomic outlook and given its backward-looking and predominantly biased information, what is the influence of negative and positive shocks in EPU on the yield spread and the forecasting actions taken by the financial market agents and the monetary policy authority in Japan? Based on the NARDL method adopted, we successfully explore short- and long-run asymmetric reactions in financial variables and in treasury yield spread, which is markedly sensitive to negative shocks resulting from EPU, while taking the BOJ’s Stock Purchasing Plan in October 2002 into consideration.
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