08 September 2014

ECB: Understanding the yield curve

Overview and policy comment by Vítor Constâncio on the role of the yield curve in monetary policy deliberations and the interpretation of information coming from fixed income markets.

The role of the yield curve in monetary policy deliberations

The yield curve is important mainly for two reasons. First, it is an indicator of what the market is thinking about the expected path of future monetary policy. This follows because long-term rates under certain conditions reflect expectations of the future path of short-term rates. Of course, besides future rate expectations, longer maturity yields typically contain risk premia. The quantification of these premia is not without challenges even in normal times.

The second reason results from the yield curve being a key part of the transmission mechanism of monetary policy. Therefore, it is something the central bank wants to influence, not only just learn from. In particular, while the first step in the transmission process of monetary policy is typically related to very short-term interbank interest rates, the wider transmission requires that these effects spread more widely to medium- and longer-term rates. In the next step, the monetary policy impulse spreads to the pricing of assets that are relevant for the financing conditions of households and corporations, their consumption, production and investment decisions and, finally, inflation.

The impact of the crisis

Naturally, the crisis has brought up a number of challenges for our understanding of the yield curve. For example, credit and liquidity premia have been important drivers of sovereign yields in the euro area and elsewhere, thereby complicating the process of inferring market expectations of the future path of policy, and also impairing the transmission mechanism of monetary policy to the wider economy. Moreover, high sovereign spreads in the euro area have raised the question of what is the appropriate yield curve to monitor. In an article in the July Monthly Bulletin we discussed this issue in the context of measuring the euro area risk-free rate. Should we use Bund yields, euro area average AAA rates or OIS rates, or does it depend on the matter at hand?

The crisis has also proved the important role that central banks play in influencing the yield curve through both their conventional and unconventional policies; including forward guidance, asset purchases and enhanced credit support. This raises a host of questions about the relative effectiveness of these policies, but also about conventional yield curve models and whether they adequately capture the mechanisms that explain the role of these policies, particularly given that for tractability and simplicity real-world complications like credit and liquidity premia, pricing anomalies and even the influence of the macro economy and monetary policy are often not directly considered.

Current policy questions

For all the analysis that has been done on the effects of unconventional monetary policies on the yields curve, there is still a great deal of disagreement on the effectiveness of these policies and the main channels they work through. What can be said about this and how can we best evaluate the relative impact of these policies? As well as guiding the future use of these policies, this is also important for gauging the likely impact when these policies are removed. With the Fed about to end its asset purchases and both the Fed and Bank of England expected to start raising policy rates next year, long rates should have increased. However, in the US, after an increase last year following the May tapering announcement, long rates have been decreasing since the beginning of the year in what James Hamilton has called the bond market conundrum redux.

Given that the euro area is some way from exiting non-standard policies, a related issue is on the nature of the likely spillovers of the US monetary policy. Mr. Constâncio says: "At various times in the past, we have seen US and euro yields move very closely together but they have diverged somewhat recently. In contrast, UK and US rates are currently very closely linked. What determines the degree of coupling or decoupling between yields and what can we expect going forward? And finally, when do markets expect the ECB to start raising rates? Given the role of term premia and the impact of the zero lower bound, how can we best estimate this date?“

Many of these issues are taken up in some way by the papers that are going to be discussed over the next day and a half. A couple of the papers will look at the impact of Treasury supply on yields, drawing on new research based on the US experience and also research on the economic mechanisms involved, the so-called portfolio balance channel. There are also some papers that look more specifically at recent asset purchase programmes and how they have affected yields and also the spillovers from them to other countries.

Other papers look at the impact of monetary policy on the yield curve, finding for example that monetary policy is one of the factors that explain movements in the term premium. There are also several papers that estimate so-called shadow rate models that recognise the zero lower bound that prevents interest rates going negative. There are also papers that look more specifically at euro area bonds markets during the crisis and the role of credit and liquidity premia and evidence of pricing anomalies, in both cases highlighting the role of the ECB’s interventions.

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