Term Premium Research Articles

Equilibrium Yield Curve, the Phillips Curve, and Monetary Policy

AbstractUpward‐sloping yield curves are hard to reconcile with the positive relationship between income and inflation (the Phillips curve) in consumption‐based asset pricing models. Using the U.S. and the UK data, this paper shows inflation is negatively correlated with long‐run income growth but positively correlated with cyclical income, thus enabling the model to replicate positive and sizable term premiums, along with the Phillips curve over business cycles. According to the model, a permanently low‐growth and low‐inflation environment would precipitate flatter yield curves due to constraints to monetary policy around the zero lower bound.

South Africa: 2021 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for South Africa

South Africa’s subpar economic performance over the last decade has weakened its macroeconomic fundamentals and social indicators. In response to formidable COVID-19-related challenges, government expenditure surged, and, amid declining revenue, the budget deficit widened significantly. The South African Reserve Bank (SARB) and the Prudential Authority (PA) preserved adequate liquidity conditions and financial-sector stability. The cyclical recovery from the deep contraction has been faster than expected but its strength is unlikely to be sustained. Benign global market conditions have supported asset performance, although term premia are elevated due to fiscal risks. Bank soundness indicators remain solid, but a deepening bank-sovereign nexus raises some concerns.

Asset market frictions, household heterogeneity, and the liquidity theory of the term structure

We study the channels through which monetary policy influences the term premium in a general equilibrium model. The idiosyncratic liquidity demand shock and asset market participation shock generate liquidation and reinvestment risks regarding bond holdings, and the term premium can be positive or negative depending on the relative strength of the two risks. An increase in the supply of any bond increases the interest rate of all maturities; this enhances the reinvestment risk but weakens the liquidation risk. Through this “liquidity channel,” a negative relationship between the interest rates and the term premium is generated, and the term premium becomes negative when the interest rates are sufficiently high. Moreover, households having different characteristics such as time discount rates and asset market participation rates demand different term premia, and this generates an endogenous market segmentation. Through this “heterogeneity channel,” the large-scale asset purchases program can effectively decrease the term premium at the zero lower bound. Further, the channel is more effective when the households have a greater variance in their characteristics.

Value and risk in emerging markets

▪ We expect quarterly growth rates for the global economy in 2022 to be similar to last year. Emerging market and advanced economy (AE) growth will also be similar; but that's disappointing for EMs given their faster trend growth. ▪ Global inflation fears will peak, and EM inflation rates will fall sharply during 2022 as the impact of FX depreciation washes out. But elevated commodity prices, political uncertainty, and some second round‐effects mean inflation concerns will linger through much of the year in some economies. ▪ Markets remain edgy but will reward EMs' generally strong fundamentals by H2 2022. EM current accounts have improved, institutions that delivered a massive fall in macro volatility in the last decade are mostly intact, and government debt can generally be stabilised with limited medium‐term fiscal adjustment. ▪ Political uncertainty may be more important than bloated public debt as a legacy of this pandemic. Increased poverty, inequality, and public dissatisfaction with orthodoxy has led to polarisation in Latin America and has swallowed even those previous bastions of conservatism such as Chile. ▪ EM monetary policies are mostly ahead of the curve. This could end up being the most conventional of EM policy cycles; with rates raised to counter inflation rather than market turmoil. That bodes well for a gentle end to the cycle in 2022. ▪ Yields across EM local currency sovereigns have risen sufficiently to perk interest. The steepness of the yield curve has recently hit 10‐year highs and term premia appear historically attractive. But the political and inflationary risks may keep global investors nervous a little while longer.

Banks, Maturity Transformation, and Monetary Policy

Banks engage in maturity transformation and the term premium compensates them for bearing the associated duration risk. Consistent with this view, I show that banks’ net interest margins and term premia have comoved in the United States over the last decades. On monetary policy announcement days, banks’ stock prices fall in response to an increase in expected future short-term interest rates but rise if term premia increase. These effects are reflected in the response of banks’ net interest margins and amplified for institutions with a larger maturity mismatch. The results reveal that banks are not immune to interest rate risk.

Term Premia and Short-Rate Expectations in the Euro Area

Term Premia and Short-Rate Expectations in the Euro Area

Expectations and term premia in EFSF bond yields

Expectations and term premia in EFSF bond yields

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-only and macroeconomic factors while allowing for aggregate stochastic volatility. We extract the components from the nominal and real yield curve of the United States, the Euro Area, the United Kingdom, and Japan. We find that short-rate expectations have steadily declined over the last two decades and account for the bulk of yield dynamics. Term premia increase with maturity but explain a smaller fraction of yield forecast error variance than previously documented. With regard to yield comovement, the United States generates the strongest spillovers at the long end of the yield curve, whereas the Japanese market is the top importer of shocks.

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

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

The impact of expectations on the co-integration relationship between the stock and REIT markets

This paper examines if expectations have a significant impact on the co-integration relationship between stock and real estate investment trust markets. We use two widely followed expectation indicators which are the US yield spread and the expected US stock market volatility (VIX) to test this hypothesis. The US yield spread is decomposed into two components which are the expected short-term interest rate (EF) and a variable term premium (TP) using Hamilton-Kim algorithm. A dataset covering ten developed markets is used. Using co-integration score analysis our findings indicate that expected US short-term interest rates and expected US stock market volatility have a statistically significant and positive impact on the global co-integrations of different countries. This effect is especially valid in the post-global financial crisis period. The expectation-based indicators EF and VIX, however, do not seem to have a significant impact on co-integration at regional and local levels.

The time-varying bond risk premia in China

Unlike many developed countries in which zero interest rate policies are widely adopted, there is still room for interest rate fluctuations in China. Nevertheless, the dynamics of bond yields, forward rates and risk premia still differ from the traditional understanding. This paper focuses on the Chinese treasury bonds. By OLS regressions, we find movements in the current forward rate fully reflect future bond risk premia, while other variables do not improve its performances, regardless of in- and out-of-sample predictions. This result is confirmed by a group of no-arbitrage dynamic term structure models. Moreover, the theoretical models reveal three important findings: 1. there are about 20% predictable variations in annual excess returns; 2. only the level factor risk is priced; 3. the candidate macroeconomic variables cannot contribute to the term premia structure.

Term Premia Co-movement and Global Trade Network

Term Premia Co-movement and Global Trade Network

Monetary Policy Transmission During QE Times: Role of Expectations and Term Premia Channels

Monetary Policy Transmission During QE Times: Role of Expectations and Term Premia Channels

A Preferred-Habitat Model of Term Premia, Exchange Rates, and Monetary Policy Spillovers

A Preferred-Habitat Model of Term Premia, Exchange Rates, and Monetary Policy Spillovers

Implications of Housing Frictions for the Term Premium

Implications of Housing Frictions for the Term Premium

Dynamics of bond and stock returns

A production-based equilibrium model jointly prices bond and stock returns and produces time-varying correlation between stock and real treasury returns that changes in both magnitude and sign. The term premium is time-varying and changes sign. The model incorporates time-varying risk aversion and two physical technologies with different cash-flow risks. Bonds hedge risk-aversion shocks and command negative term premium through this channel. Cash-flow shocks produce co-movement of bond and stock returns and positive term premium. Relative strength of these two mechanisms varies over time. The correlation is a powerful predictor of relative bond-stock and long-short equity returns in the data.

Interest rate rules and inflation risks in a macro‐finance model

AbstractLong‐term bond yields contain a risk premium, an important part of which is compensation for inflation risks. The substantial increase in the Fed funds rate in the mid‐2000s did not raise long‐term US Treasury yields due to the reduction in the term premium (so‐called Greenspan conundrum) which was typically thought to be exogenous for monetary policy. We show using a New Keynesian macro‐finance model that the term premium is endogenous and is greatly influenced by the specification of the Taylor rule. Finally, we estimate our model using various specifications of Taylor rule on US data in 1961–2007 by the generalized methods of moments and evaluate the performance of our model.

Lower Bound Uncertainty and Long‐Term Interest Rates

AbstractNominal interest rates are constrained by an effective lower bound, but the level of the lower bound is uncertain. This paper uses a simple shadow rate term structure model to study how lower bound uncertainty affects long‐term interest rates. A decline in lower bound uncertainty, in the sense of a mean‐preserving contraction, is associated with a drop in expected short rates. The effect on the variance of short rates, and hence the term premium, is ambiguous. A calibration to Canadian data suggests that a decline in lower bound uncertainty is associated with a modest drop in interest rates.

Modeling persistent interest rates with double-autoregressive processes

We propose a term structure model featuring double-autoregressive dynamics, which can accommodate unit roots and cointegrating relations while maintaining stationarity. In an empirical application, the model reduces in-sample misspecification and significantly improves out-of-sample yield forecasts compared with term structure models based on linear VAR dynamics. The double-autoregressive process implies term premia that resemble the term spread. We test whether these premia help in overcoming the persistence problem of stationary VAR models with mixed results. Finally, we discuss alternative interpretations of the mechanism inducing stationarity in our model.

Spillovers of US unconventional monetary policy: quantitative easing, spreads, and international financial markets

This study investigates the international spillover effects of US unconventional monetary policy (UMP)—frequently called large-scale asset purchases or quantitative easing (QE)—on advanced and emerging market economies, using structural vector autoregressive models with high-frequency daily data. Blinder (Federal Reserve Bank of St. Louis Rev 92(6): 465–479, 2010) argued that the QE measures primarily aim to reduce US interest rate spreads, such as term and risk premiums. Considering this argument and recent empirical evidence, we use two spreads as indicators of US UMP: the mortgage and term spreads. Based on data from 20 emerging and 20 advanced countries, our empirical findings reveal that US unconventional monetary policies significantly affect financial conditions in emerging and advanced countries by altering the risk-taking behavior of investors. This result 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 those that reduce the US term spread. Furthermore, the estimated financial spillovers vary substantially across countries and between and within the emerging and advanced countries that we examine in this study.