Unexpected Interest Rate Research Articles

Mortgage Debt, Hand-to-Mouth Households, and Monetary Policy Transmission

Abstract Using a representative sample of credit card holders from a leading Chinese commercial bank, we investigate how consumers respond to an unexpected interest rate decrease that automatically reduces interest expenses for all mortgage borrowers in the country and thereby generates significant positive disposable-income shocks. Our difference-in-differences analysis shows that compared with homeowners without mortgage obligations, mortgage borrowers increased their monthly credit card spending by 8.7% after the 230-bps mortgage rate reduction announced in September 2008. We find a significant spending response both immediately after the announcement and during the post-reset period. The credit card delinquency rate also decreased after the mortgage rate reset. Subsequent to an interest-rate increase episode, mortgage borrowers symmetrically reduced their credit card spending. Hand-to-mouth mortgage borrowers experienced a more pronounced spending increase. The debt-service channel plays an important role in transmitting monetary policy—our estimate implies a marginal propensity to consume 0.40–0.54 through credit card spending.

Credit Risk and the Transmission of Interest Rate Shocks

Using daily credit default swap (CDS) data going back to the early 2000s, we find a positive and significant relation between corporate credit risk and unexpected interest rate shocks around FOMC announcement days. Positive interest rate movements increase the expected loss component of CDS spreads as well as a risk premium component that captures compensation for default risk. Not all firms respond in the same manner. Consistent with recent evidence, we find that firm-level credit risk (as proxied by the CDS spread) is an important driver of the response to monetary policy shocks - both in credit and equity markets - and plays a more prominent role in determining monetary policy sensitivity than other common proxies of firm-level risk such as leverage and market size. A stylized corporate model of monetary policy, firm investment, and financing decisions rationalizes our findings.

Credit Risk and the Transmission of Interest Rate Shocks

Using daily credit default swap (CDS) data going back to the early 2000s, we find a positive and significant relation between corporate credit risk and unexpected interest rate shocks around FOMC announcement days. Positive interest rate movements increase the expected loss component of CDS spreads as well as a risk premium component that captures compensation for default risk. Not all firms respond in the same manner. Consistent with recent evidence, we find that firm-level credit risk (as proxied by the CDS spread) is an important driver of the response to monetary policy shocks – both in credit and equity markets – and plays a more prominent role in determining monetary policy sensitivity than other common proxies of firm-level risk such as leverage and market size. A stylized corporate model of monetary policy, firm investment, and financing decisions rationalizes our findings.

Towards an immunization perfect model?

AbstractImmunization is an investment strategy often used by insurance companies. Usually, this strategy takes into account the first‐ and second‐order of Taylor series (Duration and Convexity). However, the model itself has risk because of the difference between the real and estimated value via duration and convexity approximation. Therefore, the aim of this article is to find a better immunization model avoiding the effect of unexpected interest rate shocks by adding more terms of Taylor series to an immunization strategy. As criteria of efficiency, the paper checks the effect of interest rate risk in several immunization models upon a 99.5% confidence level (risk level of 1 in 200 scenarios), as required by Solvency II in Europe, to determine a better immunization strategy. This work analyses the skewness and, consequently, the fitness of adding third‐ and fourth‐order Taylor series. The main finding is that the model with four factors avoids the influence of interest rate shocks. Therefore, the capital on risk in near zero.

Can a Non-Event Be an Event? The Case of Bank Stock Returns Surrounding Unexpected Interest Rate Inaction by the Federal Reserve

In September 2015, the Federal Open Markets Committee (FOMC) opted not to act when an increase in interest rates was largely expected. Further, President Yellen’s comments were atypical. We investigate the effect of this announcement on the stock returns of US financial firms; more than a third of which experienced negative abnormal returns. The reaction; however, was not identical across firms indicating differential treatment based on individual firm characteristics. Our results suggest that institution size and classification as a commercial bank are the primary drivers. The outcomes of this study are important as they support the theory of rational pricing and market efficiency.

Mortgage Debt, Hand-to-Mouth Households, and Monetary Policy Transmission

Using a representative sample of credit card holders from a Chinese commercial bank with a 10% credit card market share, we investigate how consumers respond to an unexpected interest rate decrease that automatically reduces interest expenses for all mortgagors in the country and thereby generates significant positive disposable-income shocks. Our difference-in-differences analysis shows that compared with homeowners without mortgage obligations, mortgagors increased their monthly credit card spending by 7.2% after the 230bps mortgage rate reduction announced in September 2008. We find a significant spending response both immediately after the announcement and during the post-reset period. The credit card delinquency rate also decreased after the mortgage rate reset. Subsequent to an interest-rate-increase episode, mortgagors symmetrically reduced their credit card spending. Hand-to-mouth consumers experienced a pronounced spending increase, even among those with a high credit limit, and their response was concentrated in the post-reset period. The debt-service channel plays an important role in transmitting monetary policy—our estimate implies a marginal propensity to consume (MPC) of 0.40-0.51 through credit card spending.

The impact of monetary policy on the exchange rate: A high frequency exchange rate puzzle in emerging economies

This study investigates the impact of monetary policy shocks on the exchange rates of Brazil, Mexico and Chile. We find that even a focus on 1 day exchange rate changes following policy events – which reduces the potential for reverse causality considerably – fails to lend support for the view that associates unexpected interest rate hikes with immediate appreciations. This lack of empirical backing for the predictions of standard open economy models persists irrespective of whether we use the US Dollar or effective exchange rates, whether changes in the policy rate that were followed by exchange rate interventions are excluded, whether “contaminated” events are dropped from the analysis or whether we allow for non-linearities. We argue that it is difficult to attribute this stronger version of the exchange rate puzzle to fiscal dominance, as unexpected rate increases are not associated with increases in risk premia, and similar results are obtained in the case of Chile – a country that has had the highest possible short-term credit rating since 1995 and a debt/GDP ratio below 10%.

The Impact of Monetary Policy on the Exchange Rate: A High Frequency Exchange Rate Puzzle in Emerging Economies

This study investigates the impact effect of monetary policy shocks on the exchange rates of Brazil, Mexico and Chile. We find that even a focus on 1 day exchange rate changes following policy events -- which reduces the potential for reverse causality considerably -- fails to lend support for the conventional view that associates unexpected interest rate hikes with appreciations. This lack of empirical backing for the predictions of standard open economy models persists irrespective of whether we use the US Dollar or effective exchange rates, whether interest rate changes are anticipated or not, whether changes in the policy rate that were followed by exchange rate intervention are excluded or whether "contaminated" events are dropped from the analysis. We argue that it is difficult to attribute this stronger version of the exchange rate puzzle to fiscal dominance, as unexpected rate increases are not associated with increases in risk premia, and similar results are obtained in the case of Chile -- a country that has had the highest possible short-term credit rating since 1997 and a debt/GDP ratio below 10%. The weakness of the interest -- exchange rate link has important implications for optimal monetary policy in emerging economies.

What does a Monetary Policy Shock Do? An International Analysis with Multiple Filters*

What does a monetary policy shock do? We answer this question by estimating a new-Keynesian monetary policy dynamic stochastic general equilibrium model for a number of economies with a variety of empirical proxies of the business cycle. The effects of two different policy shocks, an unexpected interest rate hike conditional on a constant inflation target and an unpredicted drift in the inflation target, are scrutinized. Filter-specific Bayesian impulse responses are contrasted with those obtained by combining multiple business cycle indicators. Our results document the substantial uncertainty surrounding the estimated effects of these two policy shocks across a number of countries.

A realistic model for official interest rate movements and their consequences

This article extends the Vector Autoregression (VAR) methodology to examine the consequences of monetary policy decisions by considering two types of nonlinearities in the determination of official interest rates: (1) the asymmetry related to the different nature of the discrete and infrequent positive and negative interest rate movements determined by central bankers and (2) the convexity in the transmission of policy shocks induced by the nonnegativity constraint in interest rates. For the UK, we find some evidence of both types of asymmetries. In the US, responses to unexpected interest rate shocks are far more symmetric. Results highlight the importance of considering all types of asymmetries when studying monetary transmission.

Monetary policy and the exchange rate: Evaluation of VAR models

This paper examines the ability of vector autoregressive (VAR) models to properly identify the transmission of monetary policy in a controlled experiment. Simulating data from a small open economy DSGE model estimated for Australia, we find that sign-restricted VAR models do reasonably well at estimating the responses of macroeconomic variables to monetary policy shocks. This is in contrast to models that use recursive zero-type restrictions, for which inflation can rise following an unexpected interest rate increase while the exchange rate can appreciate or depreciate depending on the ordering of the variables. Sign-restricted VAR models seem to be able to overcome puzzles related to the real exchange rate, provided that a sufficient number of different types of shocks are identified. Despite delivering the correct sign of the impulse responses, central tendency measures of sign-restricted VAR models can, however, be misleading and hardly ever coincide with the true impulses. This finding casts doubt on the common notion that the median impulses are the ‘most probable’ description of the true data-generating process.

Interest rate sensitivity of US property/liability insurer stock returns

PurposeThe purpose of this study is to investigate interest rate sensitivity of the US property/liability (P/L) insurers stock returns using various return generating process models incorporating different interest rate changes such as actual interest rate changes, unexpected interest rate changes and orthogonalized market returns.Design/methodology/approachThe study follows the 1974 two‐index model by Stone. In the two‐index model, three different interest rate indices are tested one at a time to examine if interest rate sensitivity of the insurers stock returns, if any, is vulnerable to an interest rate index used.FindingsIt is found that the US P/L insurers' stock returns are sensitivity to interest rate changes. The impact of actual interest rate changes on the stock returns is little different from that of unexpected interest rate changes, which is consistent with findings in the banking literature. When orthogonalized market returns are used in the models in lieu of actual market returns, the statistical significance on the estimated interest rate sensitivity of the returns improves. Consistent with extant studies of financial institution's interest rate sensitivity, the paper also reports that the interest rate sensitivity of insurer stock returns is time varying.Research limitations/implicationsDue to the data availability, the period studied is between 1992 and 2001. However, the sample period does not weaken the findings of the study. In addition, future research could incorporate the insurers' balance sheet items to investigate which balance sheet items (i.e. investment in bonds, stocks and other items on asset side and reserves and other items on liability side) explain most interest rate sensitivity.Practical implicationsInvestors can adopt the findings of this study in creating or adjusting their portfolio with the US P/L insurers in it. The insurers stock returns are more sensitive to changes in long‐term interest rate when the underwriting profit increases and the stock returns are more sensitive to changes in short‐term interest rate when the underwriting profit decreases.Social implicationsAlthough generalization is difficult and the conclusion is not as convincing as it could be because only one underwriting cycle is sampled, it is still noteworthy to recognize that the insurers' interest rate sensitivity is closely related to the insurance industry's underwriting cycle or performance.Originality/valueThis is the first study reporting the association between the interest rate sensitivity of the US stock returns and the underwriting performance.

Monetary policy shocks and stock returns: evidence from the British market

This paper examines the impact of anticipated and unanticipated interest rate changes on aggregate and sectoral stock returns in the United Kingdom. The monetary policy shock is generated from the change in the 3-month sterling LIBOR futures contract. Results from time-series and panel analysis indicate an important structural break in the relationship between stock returns and monetary policy shifts. Specifically, whereas before the credit crunch, the stock market response to both expected and unexpected interest rate changes is negative and significant; the relationship becomes positive during the credit crisis. The latter finding highlights the inability, so far, of monetary policymakers to reverse, via interest rate cuts, the negative trend observed in stock prices since the onset of the credit crisis.

The euro area stock market channel: Does one size fit all?

This paper analyzes the first part of the stock market channel of monetary policy in the euro area. We find heterogeneous reactions of euro area stock markets to unexpected ECB’s interest rate decisions. Splitting all markets into two groups, covering the stock markets reacting significantly to monetary policy shocks and the ones which do not, each sub-group reveals a higher degree of homogeneity. Interestingly, the markets, which react significantly to unexpected interest rate decisions are the markets with the highest stock market capitalization. In general, we find ECB’s decisions to be well anticipated by stock markets.

European Stock Markets and the ECB's Monetary Policy Surprises*

AbstractThis paper contributes to the literature measuring the response of stock markets to monetary policy actions. We analyse the reaction of European stock market returns to unexpected interest rate decisions by the European Central Bank (ECB). Endogeneity between interest rate changes and stock returns is taken into account using the identification through the heteroscedasticity approach. Relying on different methods to extract monetary policy shocks, we find a negative and significant relation between unexpected ECB decisions and European stock market performance. Moreover, monetary policy decisions of the ECB are well anticipated by the market, implying that the central bank successfully communicates its monetary policy.

Stock Market Sensitivity to U.K. Firms' Pension Discounting Assumptions

AbstractNew U.K. pension accounting regulations significantly increase the exposure of the balance sheets of U.K. firms to volatilities in pension fund valuations. We examine whether the abnormal returns of firms that voluntarily used market‐based pension discount rates are significantly different from the abnormal returns of industry‐matched pair samples of firms that retained traditional cost‐based valuation assumptions during the period surrounding the release of the related exposure draft. We also examine the interest rate sensitivity of stock price returns over the 4‐year period before and after the announcement date. Consistent with our hypotheses, U.K. stock price returns incorporate the effect of unexpected interest rate changes on sources of pension earnings for firms that voluntarily switched to market‐based assumptions but do not incorporate these effects for firms that did not switch. These results suggest that unexpected changes in interest rates have a differential effect on a firm's sources of pension, financial, and core earnings.

Do Emerging Financial Markets React to Monetary Policy Announcements? The Case of Poland

This paper provides evidence on the short-run reactions of an emerging financial market to monetary policy announcements. We employ an instrumental variable estimation approach based on the identification through heteroscedasticity technique to estimate the impact of nominal and unexpected official interest rate changes on asset prices in Poland. The new methodology controls for possible feedback relations between financial variables and the official interest rate changes. The measures of unexpected interest rate changes are extracted from the implied forward interest rates on the money market. In the analysis, the short-term interest rates respond significantly to the official interest changes, but neither the long-term interest rates, stock indices, nor foreign exchange rates react to monetary announcements in the expected direction. The unexpected monetary policy changes have stronger influence on the money market than the nominal changes in the official interest rate on the days of the monetary policy announcements.

Interest rate sensitivity and risk premium of property stocks

This study examines the relationship between interest rate risk and returns of traded property stocks from an asset pricing perspective. Three exogenous factors are included in the APT model, in particular unexpected long-term interest rate fluctuation, unexpected market returns and unexpected industry returns. Using the weekly returns of 18 property stocks listed in Singapore between 1992 and 2001, an Iterated Non-linear Seeming Unrelated Regression (ITNLSUR) technique was employed to simultaneously estimate the sensitivities of these factors and how they are priced. Consistent with existing empirical evidence, the regression results show that the interest rate risk of property stocks is systematic and is priced in the APT framework. The study also reveals that the pricing of the interest rate risk is sensitive to the prevailing market conditions.

Survey Data and the Interest Rate Sensitivity of US Bank Stock Returns

In this paper, we provide empirical evidence on the interest rate sensitivity of the stock returns of the twenty largest US bank holding companies. The main contribution of the paper is the use of survey data to model the unexpected interest rate variable, which is an alternative approach to the existing literature. We find evidence of significant negative interest rate sensitivity during the early 1980s, and evidence of declining significance in the late 1980s and early 1990s. This result is also obtained when using the forecast errors of ARIMA processes to model the unexpected movement in the interest rate.

Modeling the conditional mean and variance of the short rate using diffusion, GARCH, and moving average models

This article introduces a two‐factor‐discrete‐time‐stochastic‐volatility model that allows for departures from linearity in the conditional mean and incorporates serially correlated unexpected news, asymmetry, and level effects into the definition of conditional volatility of the short rate. The new class of econometric specifications nests many popular existing symmetric and asymmetric GARCH as well as diffusion models of the short‐term interest rate. This study attempts to determine the correct specification of conditional mean and variance of the short rate by developing a more general econometric framework that allows for nonlinear effects in the drift of the short rate, and that defines the conditional volatility as a nonlinear function of unexpected information shocks and interest rate levels. The existing and alternative models are compared in terms of their ability to capture the stochastic behavior of the short‐term riskless rate. The empirical results indicate that the relative performance of the two‐factor models in predicting the future level and variance of interest‐rate changes is superior to the nested models. © 2000 John Wiley & Sons, Inc. Jrl Fut Mark 20:717–751, 2000