FRBSF Economic Letter
2003-15; June 6, 2003
What Makes the Yield Curve Move?
One common misperception about monetary policy is that the Federal Reserve
controls all interest rates. In fact, the Fed controls only a very short-term
rate, the federal funds rate; this is the rate banks charge each other
for overnight loans of reserves. Yet Fed policymakers—and central
bankers generally—are vitally concerned with the behavior of interest
rates of all maturities. In particular, policymakers would like to understand
how a change in short-term rates will affect medium-term and long-term
rates, because these latter rates determine the borrowing costs people
and firms face, which, in turn, determine aggregate demand in the economy.
The yield curve, which plots a set of interest rates of bonds of different
maturities, describes the relationship among short-term, medium-term,
and long-term rates at a given point in time. It has been the subject
of much research in the finance literature, because it is the natural
starting point for pricing fixed-income securities and other financial
assets. While this research has provided useful statistical explanations
of movements in the yield curve, it has not focused on what causes the
yield curve to move. This Economic Letter reviews some of the latest
studies in both finance and macroeconomics that have explored the macroeconomic
determinants of the yield curve.
Finding the common factors
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Typically, the yield curve depicts a line that rises from lower interest
rates on shorter-term bonds to higher interest rates on longer-term bonds.
Researchers in finance have studied the yield curve statistically and
have found that shifts or changes in the shape of the yield curve are
attributable to a few unobservable factors (Dai and Singleton 2000). Specifically,
empirical studies reveal that more than 99% of the movement of various
Treasury bond yields are captured by three factors, which are often called
"level," "slope," and "curvature" (Litterman
and Scheinkman 1991). The names describe how the yield curve shifts or
changes shape in response to a shock, as shown in Figure 1. Panel A of
Figure 1 illustrates the influence of a shock to the "level"
factor on the yield curve. The solid line is the original yield curve,
and the dashed line is the yield curve after the shock. A "level"
shock changes the interest rates of all maturities by almost identical
amounts, inducing a parallel shift that changes the level of the whole
yield curve. Panel B shows the influence of the "slope" factor
on yield curve. The shock to the "slope" factor increases short-term
interest rates by much larger amounts than the long-term interest rates,
so that the yield curve becomes less steep and its slope decreases. Panel
C shows the response of the yield curve to a shock to the "curvature"
factor. The main effects of the shock focus on medium-term interest rates,
and consequently the yield curve becomes more "hump-shaped"
than before.
Various models have been developed and estimated to characterize the
movement of these unobservable factors and thereby that of the yield curve
by financial economists and bond traders in asset-pricing exercises. Few
of these models, however, provide any insight about what these factors
are, about the identification of the underlying forces that drive their
movements, or about their responses to macroeconomic variables. Yet these
issues are of most interest to central bankers and macroeconomists.
Macroeconomic interpretations of why the yield
curve moves
Macroeconomists view the Federal Reserve as controlling the short end
of the yield curve, that is, the federal funds rate, in response to fundamental
macroeconomic shocks in order to achieve its policy goal of a low and
stable inflation and maximum sustainable output. Therefore, macroeconomic
variables, through defining the state of the economy and the Federal Reserve's
policy stance, will be useful in explaining movements in the short end
of the yield curve. Furthermore, expectations about future short-term
interest rates, which determine a substantial part of the movement of
long-term interest rates, also depend upon macroeconomic variables. For
instance, when the Federal Reserve raises the federal funds rate in response
to high inflation, expectations of future inflation, economic activity,
and the path of the federal funds rate all contribute to the determination
of the long-term interest rates. Therefore, one would expect macroeconomic
variables and modeling exercises to be quite informative in explaining
and forecasting the yield-curve movements. However, until very recently,
standard macroeconomic models have not incorporated long-term interest
rates or the yield curve. And even when they have, as in Fuhrer and Moore
(1995), most of the attention is still on the correlation between the
real economy and the shortest-term interest rate in the model rather than
on the whole yield curve.
Several recent economics and finance papers have explored the macroeconomic
determinants of the unobservable factors of the yield curve identified
by empirical finance studies. Wu (2001) examines the relationship between
the Federal Reserve's monetary policy "surprises" and the movement
of the "slope" factor of the yield curve in the U.S. after 1982.
His study identifies monetary policy "surprises" in several
ways to make the analysis more robust; the results indicate a strong correlation
between such monetary policy "surprises" and the movement of
the "slope" factor over time. In particular, he finds that the
Federal Reserve's monetary policy actions exert a strong but short-lived
influence on the "slope" factor: they explain 80% to 90% of
the movement of "slope" factor, but such influences usually
dissipate in one to two months. At the same time, monetary policy "surprises"
do not induce significant changes in the "level" factor, implying
that during this period the Federal Reserve affects the yield curve primarily
through changing its slope.
Ang and Piazzesi (2001) examine the influences of inflation and real
economic activity on the yield curve in an asset-pricing framework. In
their model, bond yields are determined not only by the three unobservable
factors—level, slope, and curvature—but also by an inflation
measure and a real activity measure. They find that incorporating inflation
and real activity into the model is useful in forecasting the yield curve's
movement. However, such effects are quite limited. Inflation and real
activity help explain the movements of short-term bond yields and medium-term
bond yields (up to a maturity of one year), but most movements of long-term
bond yields are still accounted for by the unobservable factors. Therefore,
they conclude that macroeconomic variables cannot substantially shift
the level of the yield curve.
Evans and Marshall (2001) analyze the same problem using a different
approach. They formulate several models with rich macroeconomic dynamics
and look at how the "level", "slope," and "curvature"
factors are affected by the structural shocks identified in those models.
Their conclusion confirms Ang and Piazzesi's (2001) result that a substantial
portion of short- and medium-term bond yields is driven by macroeconomic
variables. However, they also find that in the long run macroeconomic
variables do indeed explain much of the movement of the long-term bond
yields, and the "level" factor responds strongly to macroeconomic
variables. For instance, their identification results indicate that the
changes in households' consumption preferences induce large, persistent,
and significant shifts in the level of the yield curve.
Tentative conclusions
Recent literature generally agrees on the effects of macroeconomic variables,
especially those of monetary policy, on the slope of the yield curve.
A monetary policy tightening generates high nominal short-term interest
rates initially, but, because of its anti-inflationary effects, these
rates quickly fall back; since long-term rates embed expectations of this
behavior of short-term rates, they rise by only a small amount. As a result,
the slope of the yield curve declines when contractionary monetary policy
shocks occur.
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The conflicting results on the macroeconomy's effects on the movement
of the level of the yield curve (Ang and Piazzesi 2001 and Evans and Marshall
2001) suggest a rich field for future research. After all, it is difficult
to believe that the structure of the macroeconomy has little effect on
long-term interest rates or on the level of the yield curve, since long-term
nominal interest rates are the sum of expected long-run inflation and
long-term real interest rates. Therefore, any structural macroeconomic
movement contributing to the determinations of long-run expected inflation
or long-term real interest rates will have a substantial influence on
the "level" factor. For instance, in an inflation-targeting
monetary regime, the inflation target is a natural anchor of expected
long-run inflation, and therefore any changes in the market's perceptions
of the inflation target will directly shift the level of the yield curve.
Figure 2 plots the "level" factor and the five-year moving average
of core consumer price inflation in the U.S. from 1962 to 2002. Clearly,
the two series are quite similar. A simple regression shows that the movement
of this inflation measure alone can explain 66% of the variability of
the "level" factor in this period. Likewise, long-term changes
in the structural economy, for example the technology innovations, will
also influence the long-term real interest rates and therefore the level
of yield curve.
Tao Wu
Economist
References
[URLs accessed May 2003.]
Ang, A., and M. Piazzesi. 2001. "A
No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic
and Latent Variables." Working Paper. Columbia University. Forthcoming,
Journal of Monetary Economics.
Dai, Q., and K. Singleton. 2000. "Specification Analysis of Affine
Term Structure Models." Journal of Finance 55 (October) pp. 1,943-1,978.
Evans, C., and D. Marshall. 2001. "Economic
Determinants of the Nominal Treasury Yield Curve." FRB ChicagoWorking
Paper 01-16.
Fuhrer, J.C. and G.R. Moore, 1995. "Monetary Policy Trade-offs and
the Correlation between Nominal Interest Rates and Real Output."
American Economic Review 85 (March) pp. 219-239.
Litterman, R., and J. A. Scheinkman. 1991. "Common Factors Affecting
Bond Returns." Journal of Fixed Income 1.
Wu, T., 2001. "Monetary
Policy and the Slope Factor in Empirical Term Structure Estimations."
FRB San Francisco Working Paper 2002-07.
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