Term Premium Research Articles

Dissecting long-term Bund yields in the run-up to the ECB’s public sector purchase programme

In the run-up to the ECB’s public sector purchase programme in March 2015, German government bond yields declined significantly. Using an affine term structure model, we provide evidence that the yield declines are almost fully attributable to a decline in the term premium as opposed to the expectations component. This speaks in favour of a portfolio re-balancing channel being at work rather than a (policy rate) signalling channel. The result proves robust against changing the number of factors in the model, the estimation sample and the estimation approach.

The Term Structure of Liquidity Premium

We analyze the term structure of Treasury liquidity premium (LP). Through a model where illiquidity shocks are alleviated by holding Treasuries, we show that LP term structure is shaped by expectations of future market liquidity, liquidity term premium, and Treasury supply. As predicted, the LP term structure is downward-sloping in recessions but upward-sloping in booms, and forward LP predicts future LP and market liquidity. Furthermore, LP is quantitatively important for monetary policy pass-through: LP dampens the pass-through of interest rate policy yet strengthens the pass-through of quantitative easings. We also use LP to infer the term structure of Treasury safety premium.

AN ESTIMATED DSGE MODEL WITH LEARNING BASED ON TERM STRUCTURE INFORMATION

Agents can learn from financial markets to predict macroeconomic outcomes, and learning dynamics can feed back into both the macroeconomy and financial markets. This paper builds on the adaptive learning (AL) model of [Slobodyan, S. and R. Wouters (2012a) American Economic Journal: Macroeconomics 4, 65–101.] by introducing the term structure of interest rates. This extension enables term structure information to fully characterize agents’ expectations in real time. This feature addresses an imperfect information issue neglected in the related AL literature. The term structure of interest rates results in a strong channel of persistence driven by multi-period forecasting. Including the term structure in the AL model results in a model fit similar to that obtained in the rational expectation (RE) version of the model, but it greatly reduces the importance of other endogenous sources of aggregate persistence such as price and wage stickiness and the elasticity of the cost of adjusting capital. The model estimated also shows that term premium innovations are a major source of persistent fluctuations in nominal variables under AL. This stands in sharp contrast to the lack of transmission of term premium shocks to the macroeconomy under REs.

Monetary Policy Uncertainty and the Response of the Yield Curve to Policy Shocks

AbstractThis paper studies the nonlinear response of the term structure of interest rates to monetary policy shocks and presents a new stylized fact. We show that uncertainty about monetary policy changes the way the term structure responds to monetary policy. A policy tightening leads to a significantly smaller increase in long‐term bond yields if policy uncertainty is high at the time of the shock. We also look at the decomposition of bond yields into expectations about future policy and the term premium. The weaker response of yields is driven by the fall in term premia, which fall more strongly if uncertainty about policy is high. Conditional on a monetary policy shock, higher uncertainty about monetary policy tends to make securities with longer maturities relatively more attractive to investors. As a consequence, investors demand even lower term premia. These findings are robust to the measurement of monetary policy uncertainty, the definition of the monetary policy shock, and to changing the model specification.

Popularity: A Bridge between Classical and Behavioral Finance

Popularity is a word that embraces how much anything is liked, recognized, or desired. Popularity drives demand. In this book, we apply this concept to assets and securities to explain the premiums and so-called anomalies in security markets, especially the stock market. Most assets and securities have a relatively fixed supply over the short or intermediate term. Popularity represents the demand for a security — or perhaps the set of reasons why a security is demanded to the extent that it is — and thus is an important determinant of prices for a given set of expected cash flows. A common belief in the finance literature is that premiums in the market are payoffs for the risk of securities — that is, they are “risk” premiums. In classical finance, investors are risk averse, and market frictions are usually assumed away. In the broadest context, risk is unpopular. The largest risk premium is the equity risk premium (i.e., the extra expected return for investing in equities rather than bonds or risk-free assets). Other risk premiums include, for example, the interest rate term premium (because of the greater risk of longer-term bonds) and the default risk premium in bond markets. There are many premiums in the market that may or may not be related to risk, but all are related to investing in something that is unpopular in some way. We consider premiums to be the result of characteristics that are systematically unpopular — that is, popularity makes the price of a security higher and the expected return lower, all other things being equal. Preferences that influence relative popularity can and do change over time. These premiums include the size premium, the value premium, the liquidity premium, the severe downside premium, low volatility and low beta premiums, ESG premiums and discounts, competitive advantage, brand, and reputation. In general, any type of security with characteristics that tend to be overlooked or unwanted can have a premium. The title of this book refers to a bridge between classical and behavioral finance. Both approaches to finance rest on investor preferences, which we cast as popularity.

Interest Rates Under Falling Stars

Macro-finance theory implies that trend inflation and the equilibrium real interest rate are fundamental determinants of the yield curve. However, empirical models of the terms structure of interest rates generally assume that these fundamentals are constant. We show that accounting for time variation in these underlying long-run trends is crucial for understanding the dynamics of Treasury yields and predicting excess bond returns. We introduce a new arbitrage-free model that captures the key role that long-run trends play for interest rates. The model also provides new, more plausible estimates of the term premium and accurate out-of-sample yield forecasts.

Intermediary-Based Equity Term Structure

New empirical facts show that equity term premium is counter-cyclical, while the term structure of equity yield is pro-cyclical and switches sign between expansions and recessions. We decompose the term structure of equity yield into an equity term premium and a mean reversion component about the expected changes in future yields to understand this seemingly contradictive evidence. Although the first component is counter-cyclical, we show the second mean reversion component dominantly drives the pro-cyclical fluctuations of the overall equity yield curve. We propose a financial intermediary-based asset pricing model to quantitatively account for both facts simultaneously. In our model, the mean reversion component is endogenously driven by the time-varying tightness of the intermediaries' leverage constraint. We demonstrate that the cyclical pattern of equity term structure imposes a strong discipline on the speed of mean reversion of discount rate for any standard asset pricing models. In the standard calibration of long-run risks model Bansal and Yaron (2004) and habit model Campbell and Cochrane (1999), the mean reversion speed of discount rate is too slow to account for a negative correlation between equity yield curve and equity term premium.

Measuring Bond Investors’ Risk Appetite Using the Interest Rate Term Structure

The distribution of term premia includes additional information beyond that contained in the traditional three-parameter decomposition of the Treasury yield curve. The author finds that the position and the size of the curvature hump are both important. A yield curve hump positioned at longer maturities appears to be consistent with lengthier time horizons of investors and with more risk-seeking behavior. The author finds that this new parameter Granger drives both future US economic activity and bond returns. TOPICS:Fixed income and structured finance, fixed-income portfolio management, statistical methods

Comment on “The long-run information effect of Central Bank communication” by Stephen Hansen, Michael McMahon, and Matthew Tong

Hansen et al. (2019) highlight an uncertainty effect on long-term interest rates, particularly term premia, of central bank communication using novel measures constructed directly from the text of the Bank of England’s Inflation Report. This comment takes a more in-depth look at these narrative measures, showing that the measures identified as being important for explaining the short-rate expectations and term premia components of interest rates are equally important for explaining overall interest rate movements at all maturities. Furthermore, the signals identified as being important for long-term rates and term premia are indeed correlated with perceptions of uncertainty, but are also related to changes in longer-horizon economic forecasts. This suggests a more balanced view of central bank communications transmitting to long-term interest rates through both short-rate expectations and uncertainty.

How does government spending news affect interest rates? Evidence from the United States

This study analyzes the effects of news shocks to U.S. government spending on interest rates, especially long-term interest rates, and investigates the role of agents’ expectations in the propagation of government spending to interest rates. Using large Bayesian vector autoregressive models with sufficient information, we find that news about increases in government spending induce significant increases in both short- and long-term interest rates while the effects of government spending surprise shocks on interest rates are mixed and ambiguous. Government spending news shocks in the baseline model account for around 10% of the variance in forecast errors in long-term interest rates, which is much more important than government spending itself. Using empirical dynamic term structural models, we further decompose increases in long-term interest rates into changes in expectations of future monetary policy and changes in term premiums. We find that an increase in the long-term interest rate after a positive government spending news shock mainly reflects higher expected future short-term interest rates, which demonstrates the importance of the coordination between fiscal and monetary policy communication.

The long-run information effect of central bank communication

Why do long-run interest rates respond to central bank communication? Whereas existing explanations imply a common set of signals drives short and long-run yields, we show that news on economic uncertainty can have increasingly large effects along the yield curve. To evaluate this channel, we use the publication of the Bank of England’s Inflation Report, from which we measure a set of high-dimensional signals. The signals that drive long-run interest rates do not affect short-run rates and operate primarily through the term premium. This suggests communication plays an important role in shaping perceptions of long-run uncertainty.

Hyperbolic or Exponential Time Discounting Function? Empirical Evidence Using a Conditional Consumption Capital Asset Pricing Model

The main objective in this article is to shed new light on the term structure of subjective time preference rates using a conditional Consumption Capital Asset Pricing Model. Following Samuelson’s (1937)’s suggestion, we analyze the concept of “time consistency”. More precisely, we challenge the relevance of the exponential time discounting function assumption, which leads to a constant subjective time preference rate. First, we develop a parsimonious, consumption-based model of the term structure of interest rates. Second, we test its implications for US monthly data from 1970:4 to 2013:1. We use a bivariate two-factor model of inflation and real consumption (through a VAR-GARCH process) to condition the term premiums of bonds. Our results clearly cast doubt on the assumption of a flat term structure, as implied by the standard exponential discounting function. A decreasing term structure of time preference rates is reported. It is particularly clear for the 1991-2013 period. Our results give strong support for the hyperbolic time discounting function hypothesis and open the way for the hypothesis of time varying time preference rates.

A re-evaluation of the term spread as a leading indicator

Forecasting the evolution path of macroeconomic variables has always been of keen interest to policy makers and market participants. A common tool used in the relevant forecasting literature is the term spread of Treasury bond yields. In this paper, we decompose the term spread into an expectation and a term premium component and evaluate the informational content of each component in forecasting the GDP growth rate and inflation in various forecasting horizons. In doing so, we employ alternative decomposition procedures and introduce the Support Vector Regression (SVR) methodology from the field of Machine Learning, coupled with linear and non-linear kernels as a novel forecasting method in the field. Using rolling windows in producing point and conditional probability distribution forecasts we find that neither the term spread, nor its decomposition components possess the ability to accurately forecast output growth or inflation. Our findings extend the existing literature, since they are focused on an explicit out-of-sample evaluation in contrast to most existing empirical studies that produce only in-sample forecasts. To strengthen our findings, we also consider several control variables suggested in the relevant literature without significant qualitative differences from the initial results. The main innovation of our approach stems from the use of the non-linear Support Vectors Machine methodology, that is introduced for the first time in this line of research for forecasting out-of-sample.

Risk Management for Sovereign Debt Financing with Sustainability Conditions

We develop a model of debt sustainability analysis with optimal financing decisions in the presence of macroeconomic, financial and fiscal uncertainty. We define a coherent measure of refinancing risk, and trade off the risks of debt stock and flow dynamics, subject to debt sustainability constraints and endogenous risk and term premia. We optimize both static and dynamic financing strategies, compare them with several simple rules and consol financing to demonstrate economically significant effects of optimal financing, and show that the stock-flow tradeoff can be critical for sustainability. We quantify the minimum refinancing risk and the maximum rate of debt reduction that a sovereign can achieve given its economic fundamentals, and extend the model to identify optimal timing for debt flow adjustments that allow the sovereign to go beyond these limits. We put the model to the data on three real-world cases: a representative euro zone crisis country, a low-debt country (Netherlands) and a high-debt country (Italy). These applications illustrate the use of the model in informing diverse policy decisions on sustainable public finance. The model is part of the European Stability Mechanism toolkit to assess debt sustainability and repayment capacity of member states in the context of financial assistance.

Decomposing global yield curve co-movement

Abstract This paper studies the co-movement of global yield curve dynamics using a Bayesian hierarchical factor model augmented with macroeconomic fundamentals. Our data-driven approach is able to pin down the drivers of yield curve dynamics and produce plausible term premium estimates. We reveal the relative importance of global shocks through two transmission channels: policy and risk channels. Global inflation is the most important core macro fundamental affecting international yields, operating through a policy channel. Two identified global yield factors significantly influence global yield co-movements through a risk channel.

A survey-based estimation of the Swiss franc forward term premium

This paper sheds light on Swiss franc LIBOR futures, which are often used to derive interest rate expectations. We show that the differences between LIBOR futures and realized rates (excess returns) are, on average, positive over the last 25 years. Using interest rate surveys, we decompose excess returns into a (forward) term premium and forecast errors. The decomposition reveals that the bulk of excess returns arises from forecast errors, while the term premium is, on average, zero but time varying. We find that the term premium positively correlates with the business cycle, interest rate developments, and in absolute values increases with interest rate uncertainty.

Back to the Real Economy: The Effects of Risk Perception Shocks on the Term Premium and Bank Lending

We develop a dynamic stochastic general equilibrium framework that can account for important macroeconomic and financial moments, given Epstein-Zin preferences, heterogeneous banking and third-order approximation methods that yield a time-varying term premium that feeds back to the real economy. A risk perception shock increases term premia, lowers output, and reduces short-term credit in the private sector in response to higher loan rates and constrained borrowers, as banks rebalance their portfolios. A ‘bad’ credit boom, driven by investors mispricing risk, leads to a more severe recession and is less supportive of economic growth than a ‘good’ credit boom based on fundamentals.

Dissecting the Yield Curve: The International Evidence

We develop a term structure model that decomposes nominal yields into the sum of an expectation, term premium, and convexity term, and in turn of their real and inflation counterparts. The model explicitly captures the interrelation between yield factors and macroeconomic conditions while allowing for aggregate stochastic volatility. We extract the components from the nominal and real yield curve of the US, Euro Area, UK, and Japan. We find that the bulk of yield dynamics comes from short rate expectations. Term premia vary over time and increase with maturity, but account for a smaller fraction of yield variance than previously documented. Over time, we observe a sustained decline in short real rate expectations and significant convexity effects. With regard to yield comovement, the US generates the strongest spillovers at the long-end of the yield curve, whereas the Japanese market is the top importer of shocks.

How a combination of two contradicting concepts is represented: The representation of premium instant noodles and premium yogurts by different age groups

This study was conducted to investigate the representation of the association between two contradicting concepts: premium and low-priced foods (instant noodles and yogurt) by different age group. Subjects undertook free word association tasks relating to the cue words premium, instant noodles, yogurts, premium instant noodles, premium yogurts and rated their importance. Subjects comprised 150 individuals from three different age groups: the adolescents (AD), aged 13-18 years; the young adults (YA), aged 19-29 years;, and the middle-aged adults (MA), aged >30-years. Words elicited from subjects were classified into central core and peripheral elements according to their frequency of occurrence and their importance. Representations of instant noodle, premium noodles, yogurt and premium yogurt were compared to examine whether the use of the term premium has a food-specific influence or a universal effect on the development of representations. Differences in representations among age groups were investigated using correspondence analysis. The central core of both premium instant noodles and premium yogurt consisted of delicious, health, and good for health. In addition, high quality, expensive, price, and good were transferred from the representation of premium to both those of yogurt and instant noodles. This suggests that the addition of the term premium has a universal effect across food items. Addition of premium to instant noodle and yogurt increased negative emotions. The representation of premium instant noodles and premium yogurt significantly differed by age. MA associated premium food items with price while YA related them with quality aspects. These differences seemed to be associated with the experiences that each group had gathered with regard to the terms premium, instant noodles, and yogurt.

Spillovers of US Unconventional Monetary Policy to Emerging and Advanced Countries

This study investigates the international spillover effects of US unconventional monetary policy — frequently called large-scale asset purchases or quantitative easing (QE) — on advanced and emerging market economies, using VAR models with high-frequency daily data. Blinder (2010) argues that the QE measures primarily aim to reduce US interest rate spreads such as term premiums and risk premiums. Considering this argument, we use two interest rate spreads as indicators of the QE policy: the mortgage spread and term spread. Empirical findings, based on data from 20 emerging and 20 advanced countries, reveal that US unconventional monetary policies significantly affect financial conditions in both emerging and advanced countries by altering the risk-taking behavior of investors, which suggests that the risk-taking channel plays an important role in transmitting the effects of these policies to the rest of the world. The extent of these effects depends on the type of QE measures. QE measures such as purchases of private-sector securities that lower the US mortgage spread exert stronger and more significant spillover effects on international financial markets than do measures that reduce the US term spread. Furthermore, the estimated financial spillovers vary substantially across countries, as well as between and within the two country groups, emerging markets and advanced countries.