Keywords: Monetary policy, real interest rates, term premia
Changes in monetary policy have surprisingly strong effects on forward real rates in the distant future. A 100 basis-point increase in the 2-year nominal yield on an FOMC announcement day is associated with a 42 basis-point increase in the 10-year forward real rate. This finding is at odds with standard macro models based on sticky nominal prices, which imply that monetary policy cannot move real rates over a horizon longer than that over which all prices in the economy can readjust. Rather, the responsiveness of long-term real rates to monetary shocks appears to reflect changes in term premia. One mechanism that may generate such variation in term premia is based on demand effects coming from "yield-oriented" investors. We find some evidence supportive of this channel.
In this paper, we document that changes in the stance of monetary policy have surprisingly strong effects on very distant forward real interest rates. Concretely, we show that a 100 basis-point (bp) increase in the 2-year nominal yield on a Federal Open Markets Committee (FOMC) announcement day-which we use as a proxy for changes in expectations regarding the path of the federal funds rate over the following several quarters-is associated with a 42 bp increase in the 10-year forward overnight real rate, extracted from the yield curve for Treasury Inflation Protected Securities (TIPS).
Our findings can be illustrated with the FOMC's much-discussed announcement on January 25, 2012. On that date the FOMC significantly changed its forward guidance, indicating that it expected to hold the federal funds rate near zero "through late 2014" whereas it had previously only stated that it expected to do so "through mid-2013."2 In response to this announcement, the expected path of short-term nominal rates fell significantly from two to five years out, with the 2-year nominal yield dropping by 5 bps and the 5-year nominal yield by 14 bps. More strikingly, 10-year and 20-year real forward rates declined by 5 bps and 9 bps respectively. In other words, distant real forward rates appeared to react strongly to news about the future stance of monetary policy.
This finding is at odds with standard New-Keynesian macro models, in which the central bank's ability to influence real variables stems from that fact that goods prices are sticky in nominal terms. In such models, a change in monetary policy should have no impact on forward real interest rates at a horizon longer than that over which all nominal prices can readjust, and it seems implausible to think that this horizon could be anything close to ten years.3
So how does one make sense of our finding? One possibility is that the results are simply wrong in some sense-i.e., they are either not robust or non-causal. On the robustness front, one limitation of our analysis is that there is a relatively brief sample period in the US over which we can study real rates-TIPS were introduced in 1997 and reliable data only become available in 1999. In an effort to address this concern, we replicate our analysis on UK data over this same period and find broadly similar results.
With respect to causality, a worry is that movements in short-term nominal rates on FOMC announcement days may not reflect innovations to Fed policy per se, but rather just the response of the Fed to information about the future evolution of the economy. For example, suppose there is news suggesting a permanent positive productivity shock. It is possible that this shock both raises the natural (flexible-price) real interest rate in the economy forever, and at the same time leads the Fed to tighten in the short run. If so, it would be a mistake to conclude that the increase in distant forward real rates was caused by an autonomous change in Fed policy.
Although it is difficult to completely rule out this possibility, we can make some progress by comparing the results we get for FOMC announcement days to the analogous results for non-FOMC days. The idea is that non-FOMC days also have their fair share of macro news, but are less likely to be informative about shifts in the Fed's reaction function. Thus, if the elasticity of long-term real rates to short-term nominal rates is driven by macro news, this elasticity should be stronger on non-FOMC days, which arguably have a greater relative proportion of macro news and less reaction-function news. However, this prediction is not borne out in the data. If anything, we find the reverse: distant forward real rates react more strongly to changes in short-term nominal rates on FOMC days than on non-FOMC days. Although not a definitive test, this provides some support for thinking about the FOMC-announcement-day results as reflecting the causal consequences of changes in the stance of monetary policy.
Assuming that the results can be given a causal interpretation, what economic mechanism do they reflect? It is helpful to begin by noting that a movement in the 10-year forward real rate can always be decomposed into a change in the expected real rate that will prevail in 10 years, plus a change in the 10-year real term premium. A movement in the real term premium is equivalent to saying that when the Fed raises short-term nominal rates, this increases the expected return on a carry-trade strategy that borrows short-term and buys long-term real bonds.4
This decomposition suggests two broad economic channels that could be at work. The first involves monetary policy somehow moving expected future real rates at very distant horizons. If this channel were operative, it would be a form of long-run monetary non-neutrality that runs directly counter to the rational-expectations spirit of New-Keynesian models. In other words, it is hard to see how this channel could be squared with the bedrock assumption in these models, namely that nominal prices are set in a rational, forward-looking manner.
The alternative possibility is that monetary policy does not move expected future real rates far out into the future, but rather that it changes the term premia on long-term bonds. This implies that the effects on forward rates that we document should be expected to mean revert over time. To test this hypothesis, we proceed as follows. At any point in time t, we cumulate the changes in long-term forward rates that occurred solely on FOMC announcement days over the preceding three months. We then use these FOMC-announcement-day changes to forecast changes in forward rates over the subsequent twelve months. It turns out that when long-term forward rates rise on an FOMC announcement day, this portends a reversal of forward rates over the next twelve months. The evidence is thus consistent with the proposition that monetary policy shocks induce time-variation in real term premia.5
This then raises the question of why monetary policy might be influencing real term premia. In traditional representative-agent asset pricing models, term premia are pinned down by the covariance between real bond returns and investors' marginal utility. It is difficult to see why monetary shocks would change this covariance in the required direction, so we focus instead on an alternative class of supply-and-demand-based mechanisms. One specific explanation that we flesh out in detail has to do with a set of "yield-oriented" investors. We assume that these investors allocate their portfolios between short and long-term bonds, and in doing so, put some weight in their objective functions not just on expected holding-period returns, but also on current income or yield. This could be because of agency or accounting considerations that lead them to care about short-term measures of reported performance.
A reduction in short-term nominal rates leads these investors to rebalance their portfolios towards longer-term bonds, in an effort to keep their overall portfolio yield from declining too much. This in turn creates buying pressure that raises the price of the long-term bonds, and hence lowers long-term real yields and forward rates. Note that this price pressure is independent of expectations about the actual path of future short rates-it is a pure term-premium effect. And interestingly, according to this hypothesis, conventional monetary policy moves long-term real rates in much the same way as some of the Fed's recent unconventional policy measures, such as its quantitative-easing purchases of long-term Treasuries. These too are presumed to operate through a supply-and-demand effect on term premia as opposed to by changing expectations about the future path of rates.
We go on to provide some evidence that is consistent with our hypothesis about the role of yield-oriented investors. We do so by looking at the maturity of securities held by commercial banks. Banks fit with our conception of yield-oriented investors to the extent that they care about their reported earnings-which, given bank accounting rules, are based on current income from securities holdings and not mark-to-market changes in value. And indeed, we find that when the yield curve steepens, banks increase the maturity of their securities holdings. Moreover, the magnitudes of these portfolio shifts are large in the aggregate, so that if they had to be absorbed by other, less yield-oriented investors (e.g., broker-dealers or hedge funds) they could plausibly drive changes in market-wide term premia. We also find that primary dealers in the Treasury market-who, unlike banks, must mark their securities holdings to market-take the other side of the trade, reducing the maturity of their Treasury holdings when the yield curve steepens.
The ideas in this paper connect to several strands of prior research. There is a large literature which examines the impact of monetary policy surprises on long-term nominal interest rates. For example, Cochrane and Piazzesi (2002) find that a 100 bp increase in the one-month Eurodollar rate around the time of a fed-funds target change is associated with a 52 bp increase in 10-year nominal Treasury yields. They too cast this as something of a puzzle, remarking that: "the size of the coefficients is particularly startling" (page 92). In a similar vein, Gürkaynak, Sack, and Swanson (2005a) show that distant nominal forward rates respond strongly to a variety of macroeconomic news releases, including FOMC announcements.6
We sharpen the puzzle by focusing on real forward rates instead of nominal yields or nominal forward rates, which puts the long-run non-neutrality issue front-and-center. By contrast, Gürkaynak, Sack, and Swanson (2005a) argue that their results are consistent with a model in which long-run inflation expectations are not well anchored and are revised in light of incoming news. According to this explanation, monetary shocks might alter long-run inflation expectations, but would have no impact on long-run real rates.
The yield-oriented investors that drive term premia in our model are reminiscent of Rajan's (2005) account of investor behavior in a low-interest-rate environment. And the idea that supply-and-demand effects can have important consequences in the Treasury market is central to a number of recent papers, including Gagnon et al (2010), Greenwood and Vayanos (2010a, 2010b), Krishnamurthy and Vissing-Jorgensen (2011, 2012), and Vayanos and Vila (2009). An important antecedent to this work is Modigliani and Sutch (1966).
The remainder of the paper is organized as follows. In Section II, we document the strong sensitivity of long-term real forward rates to monetary policy news, and argue that this relationship is likely to be causal. In Section III, we make the case that movements in long-term forward rates around monetary policy announcements reflect changes in term premia. In Section IV, we investigate the mechanism behind these changing term premia. Section V concludes.
To get started, we need a measure of monetary policy news. There is a growing consensus that changes in the policy outlook are the primary form of monetary policy news on FOMC announcement days. Thus, building on Gürkaynak, Sack, and Swanson (2005b) and Campell, Evans, Fisher, and Justiniano (2012), our measurement strategy is based on the premise that, at least since 1994, a significant portion of the news contained in FOMC announcements is about the expected path of the federal funds rates over the next several quarters, as opposed to surprise changes in the current funds rate.7
In order to capture revisions to the full expected path of the funds rate over the coming quarters in a simple and transparent manner, we use the change in the 2-year nominal Treasury yield on FOMC announcement dates as our proxy for monetary policy news. However, as described in our robustness tests below, we obtain similar results with a variety of related variables that capture revisions in expected short rates over the following several quarters. The key is that these variables capture news about the expected medium-term path of interest rates-as opposed to only news about rates over the coming month or two.
In our baseline specification, for an FOMC meeting on day t, we compute changes from t-1 to t+1 in order to capture the full market response to the announcement. We focus on 2-day changes because Gürkaynak, Sack, and Swanson (2005b) present intra-day evidence which suggests that the market takes time to process the information contained in FOMC statements about the likely path of the funds rate. Moreover, one might expect a slightly more gradual adjustment process to the extent that some of the reaction of long-term rates is quantity-mediated-i.e., involves portfolio rebalancing by some investors-as opposed to reflecting a pure shift in the expectations of all investors. Nevertheless, our results our qualitatively similar, albeit somewhat smaller in magnitude, if we instead measure changes over the 1-day interval from day t-1 to t.
We use data from Gürkaynak, Sack, and Wright (2007, 2010) on the nominal Treasury yield curve and the real (TIPS) Treasury yield curve as updated regularly by the Federal Reserve Board. Each day they estimate the 6-parameter model of the instantaneous forward curve proposed by Svensson (1994). Zero coupon yields are then obtained by integrating along the estimated forward curve
We can decompose the n-year nominal forward rate into the sum of the forward real rate and the forward break-even inflation rate ,
In our baseline specifications, we regress changes in forward nominal rates, forward real rates, and forward break-even inflation rates on changes in 2-year nominal yields
We focus on FOMC announcement dates from 1999-present. However, we exclude five FOMC announcement dates that contained significant news about the Fed's Large Scale Asset Purchases (sometimes referred to as "QE1", "QE2" and "Operation Twist").9 We do so because the mechanism underlying long-term rate movements on these dates is potentially different from that driving market reactions to more conventional FOMC announcements.
Table 1 and Figure 1 present the basic results. Panel A of Figure 1 shows how the nominal forward curve responds to a 100 basis-point shock to short-term nominal rates. Specifically, Figure 1A plots the coefficients from regression (4a) for maturities n = 5, ..., 20 along with 95% confidence intervals. Panel B of Figure 1 decomposes the response of nominal forwards into a change in real forwards and forward breakeven inflation, plotting the coefficients from regressions (4b) and (4c). By construction, the sum of the two coefficients shown in Panel B equals the coefficient in Panel A. Table 1 lists all the regression coefficients.
Table 1 and Figure 1 show that distant nominal forwards respond significantly to changes in short-term nominal rates on FOMC days. And, surprisingly, this response is driven almost exclusively by movements in real forwards. A 100 bps shock to the 2-year nominal rate on an FOMC announcement date is associated with a 45 bps increase in 10-year nominal forwards (t = 3.54). And this 45 bps increase can be decomposed into a 42 bps rise in real forwards (t = 4.63) and a 3 bps rise in forward break-even inflation (t = 0.23). This pattern holds even as we consider more distant forwards. A 100 bps shock to 2-year nominal rates is associated with an 18 bps increase in 20-year nominal forwards (t = 1.32), which reflects a 30 bps rise in real forwards (t = 3.15) and a 12 bps decline in forward break-evens (t = -0.79).
Table 2 conducts a variety of robustness exercises. First, we vary the event window. In our baseline results, we use a 2-day window from day t-1 to day t+1. In Table 2, we report comparable results where we use a 1-day window from t-1 to t. As noted above, our results are somewhat smaller in magnitude with the 2-day window. Next we try a using a variety of alternative measures of short-run nominal rates in place of 2-year Treasury yields. These include: 1-year Treasury yields; the overnight index swap (OIS) linked to the federal funds rate; fed funds futures; and Eurodollar futures contracts. The basic take-away is that everything works similarly with any variable that captures news about the medium-term path of rates, as opposed to one that only captures what the target will be in the next few weeks. This is shown explicitly where construct the "future path of policy" news factor as in Gürkaynak, Sack, and Swanson (2005b). Finally, we vary the sample. For example, we add QE dates or the dates on which FOMC minutes are released. This has little impact on the results.
To further investigate the robustness of our results, we run the analogous set of regressions using UK data. To do so, we rely on the yield curve estimates published by the Bank of England (BOE) which employ the spline-based techniques described in Andersen and Sleath (2001). As above, we estimate regressions (4a), (4b), and (4c) on all dates when the BOE's Monetary Policy Committee (MPC) has met since 1999.10 Our proxy for news on MPC dates is the change in the 2-year nominal yield. And, as above, we compute changes from t-1 to t+1 for meetings on day t. And we drop six MPC dates from 2009 to 2011 when there was significant news about the BOE's quantitative easing operations.11
Table 3 and Figure 2 present the basic results for the UK. The estimates are generally similar to those from the US, although the magnitude of the effect is slightly smaller in the UK In particular, for the 10-year forward real rate, the coefficient on the two-year nominal yield is 0.291 in the UK as compared to 0.421 in the US.
In spite of our focus on FOMC announcement days, it could be argued that the above results may not reflect a causal impact of monetary policy innovations on long-term real rates. Rather, it could be that the Fed's policy announcement is simply a response to its private information about the future evolution of the economy, and it is the release of the Fed's private information-as opposed to news about its reaction function-that moves long-term real rates.
For example, suppose the Fed has private information to the effect that the economy's long-run growth potential is weaker than previously believed. This might cause the Fed to ease policy, reducing the expected path of nominal rates over the next several quarters. And once disclosed, the same information might also lead investors to expect the long-run natural real rate to decline. However, the movement in long-term real rates would not be a causal consequence of monetary policy in this case, as it would have happened even had the Fed chosen not to ease.
This reverse-causality story is already somewhat suspect on an a priori basis, because it presumes that the Fed has material private information about the very long-run evolution of the economy. And a variety of studies have shown that the Fed does not have any forecasting advantage relative to private analysts more than a few quarters into the future.12
Nevertheless, we take a crude stab at testing the reverse-causality hypothesis. To do so, we compare our results above to those on all non-FOMC-announcement days. The intuition for this experiment is as follows. Non-FOMC days see the release of a variety of fundamental macro news items-the same kind of macro news that the Fed is ostensibly revealing with its FOMC announcements in the private-information story-but are less likely to bring news about the Fed's reaction function. Thus if the elasticity of long-term real rates to short-term nominal rates is simply driven by macro news, as is posited in reverse-causality hypothesis, this elasticity should be stronger on non-FOMC days, which arguably have a greater relative proportion of macro news as compared to reaction-function news.
To implement the test, we estimate
for n = 5, 10, and 20 using all days in the sample. The results are displayed in Table 4. The key coefficient of interest is that on the interaction term, d, which captures how the elasticity of long-term real forward rates to short-term nominal rates on FOMC days differs from that on non-FOMC days. According to the reverse-causality hypothesis, we would expect this coefficient to be negative. In fact, it is generally positive, although only marginally significant. The point estimates for 10-year real forwards suggest that the elasticity on non-FOMC days is 0.268, as compared to a value of 0.421 on FOMC days.
Thus the results in Table 4 fail to support the reverse-causality hypothesis.13 Of course, this is not the same thing as having a clean instrument for exogenous shocks to the Fed's reaction function. So while we believe the balance of the evidence favors a causal interpretation of the role of monetary policy on long-term real forwards, the identification is admittedly not airtight.
If one accepts the premise that monetary policy does indeed have an important causal impact on long-term real forward rates, the natural next question to ask is whether this reflects changes in expected future real rates or changes in term premia. If it is the former, this would represent a direct challenge to the notion that monetary policy is neutral in the long run, since the implication would be that a change in policy today has a large effect on the expected level of the real rate 10 years or more into the future. If it is the latter, this opens the door to a novel monetary transmission channel. And one would then want to understand the strength and persistence of this term premium effect, as well as the economic mechanisms that give rise to it.
As a matter of bond accounting, a change in the n-year forward real rate can always be decomposed into a change in the expected real rate that will prevail in n-1 years, plus a change in the n-year real term premium.14 Letting be the n-year forward rate at time t, the realized return on an n-period zero-coupon bond from t to t+1, and the yield on a one-period bond at time t (i.e., the short rate), it is straightforward to show that, for changes in distant forward rates over a short horizon, we have
To test whether movements in distant forward rates reflect news about future short rates or news about future term premia, we run regressions in which we use 3-month changes in the forward rate, , to forecast subsequent changes in forward rates over a 12-month horizon, . Since , this is directly equivalent to a test of equation (6). That is, if movements in forward rates were only informative about future short rates, and not about excess bond returns, there would be no predictable mean reversion in forward rates. Conversely, if we do find evidence of mean reversion in forward rates, this maps into a particular trading strategy that earns excess returns. For example, if the 10-year forward rate jumps up today and is expected to fall back over the next year, this is the same as saying that 10-year bonds are expected to outperform 9-year bonds over the next year.
We face an important data limitation in this forecasting exercise. Ideally, we would like to do everything in real terms, since our focus thus far has been on real rates. However, given the short span of the TIPS data and the fact that we are we are working with 12-month returns, this leaves us with only dozen fully independent observations. So we worry about relying solely on TIPS forecasting regressions from 1999-2011.
Instead we first focus on the nominal data, which allow us to consider a longer sample. We restrict attention to the 1987-present (post-Volcker) period in which inflation expectations have been relatively well-anchored in the US. It seems plausible to use the nominal data as a proxy for the missing real data over this period. In particular, our key independent variable is the change in the 10-year forward rate on FOMC announcement days. For the post-1999 period for which we have data on both, the correlation between the real and the nominal versions of this variable is 0.77. And the correlation between the nominal and real versions of our dependent variable-the change in forwards over 12-month intervals-is 0.82. This suggests that using nominal data in place of real data to extend the sample is a reasonable way to proceed.
Panel A of Table 5 presents these forecasting results. In column (1), we begin by estimating the following univariate regression
In column (2) we present instrumental variables (IV) estimates of equation (7) using as an instrument for . These IV estimates enable us to examine the reversion following movements in forward rates that are themselves a response to changes in short rates. The large IV estimates suggest that the response of forwards to changes in short rates is quickly reverted away. Indeed the IV estimate of b = -1.078 (t = -2.13) implies that the initial response is completely reversed within 12 months. Thus, the IV estimates are consistent with the idea that the response of distant forwards to short rates primarily reflects movements in term premia as opposed to changes in expected short rates.
Columns (3) and (4) show that similar results hold when we control for the forward rate spread -i.e., the difference between the 10-year forward rate and the short rate-as in Fama and Bliss (1987). Our results also hold up if we control for other bond forecasting variables, including the term spread as in Campbell and Shiller (1989) or linear combinations of forward rates as in Cochrane and Piazzesi (2005) and Cieslak and Pavlova (2011).
In column (5) we break the change in the 10-year forward rate into the component that occurs on FOMC days and the component that occurs on other non-FOMC days, and use these separately as predictive variables
As shown in column (5), the coefficient on the FOMC-days part of the forward rate change (b = -0.564, with a t-statistic of -1.69) is somewhat larger than its counterpart for non-FOMC days (c = -0.321, with a t-statistic of -2.86). The IV estimates, where we instrument for and with and respectively, also result in a larger coefficient for the FOMC-days piece than the non-FOMC-days piece. Although the statistical significance of the FOMC-days piece is marginal, the point estimates suggest that movements in forward rates on FOMC days contain just as much-and perhaps even slightly more-discount rate news as those on non-FOMC days.
Panel B of Table 5 presents the real analogs to equations (7) and (8) for the 1999-present period. Reassuringly, we obtain similar point estimates using the TIPS data over this shorter sample period.16 For example, the coefficient on the change in the real forward rate on FOMC announcement days from the OLS regression in column (5) is -0.567 (t = -2.05), as compared to a value of -0.564 in the nominal data using data back to 1987.
Of course, whether the sample period is 1987-present or 1999-present, any attempt to forecast annual bond returns with a relatively small number of independent observations should be viewed with a healthy dose of skepticism. At the same time, it is important to be clear on the competing theories that are at play in this case and how they might shape one's priors. Often when one is trying to predict asset returns, the null of no predictability has a strong ex ante theoretical standing, and so it may make sense to set a high bar for rejecting the null. But in this case, recall that a null of no predictability is equivalent to the proposition that monetary policy shocks have a powerful effect on expected real rates 10 years into the future-in other words, that monetary policy is non-neutral over very long horizons. For somebody who finds such a proposition hard to swallow, our forecasting results offer an alternative interpretation that may be more palatable, even if the statistical significance of these results is not overwhelming.
Another way to illustrate the mean reversion of forward rates is to examine their impulse response to an initial shock to short rates. To do this, we again work with daily data and the 10-year instantaneous forward rate. We begin by separately estimating
Panel A of Figure 3 plots the coefficient b(k) from estimating equation (9) on all days (i.e., FOMC and non-FOMC) from 1987-present.17 The graph shows that a 100 bps shock to short-term nominal rates generates a 51 bps impulse to 10-year nominal forwards upon impact-i.e., for k = 1. This effect is then gradually reverted away over the following 9 months, consistent with the idea that the initial response reflects a change in the term premium as opposed to news about short rates. Panel B repeats the same exercise, restricting attention to only FOMC dates. Consistent with our prior findings, the picture suggests that an FOMC-day impulse to forward rates dissipates especially rapidly. However, as shown by the wide confidence intervals in Panel B, the standard errors increase by a factor of three or four when we focus on just FOMC days, so any inferences about the exact timing of the mean reversion are necessarily tentative in this case.
We next turn to the TIPS data from 1999-present and estimate
In summary, both the forecasting regressions and the impulse response functions suggest that the response of distant real forwards to nominal short rates reflects variation in term premia as opposed to news about short-term real rates far into the future. Moreover, it looks like these changes in term premia are relatively short-lived, with most of the mean reversion in forward rates occurring within a one-year horizon.
Let us review the narrative to this point. We began by documenting that monetary policy shocks are associated with large changes in distant real forward rates, and by arguing that this association is likely to be causal in nature. Next, we showed that these changes in distant forward rates appear to reflect variation in term premia as opposed to changes in expected future short rates. This leaves us with a fundamental question: what is the economic mechanism by which innovations to monetary policy influence real term premia?
Broadly speaking, there are two types of stories that one can tell. The first appeals to the standard consumption-based asset-pricing model in which the real term premium is pinned down by the covariance between real bond returns and the marginal utility of the representative investor. We discuss this theory below and argue that it is unlikely to explain our results.
An alternative class of models is one in which markets are partially segmented, and term premia are determined by supply-and-demand effects. This is how most observers have thought about the effects of the Fed's quantitative-easing policies, for example. These models are somewhat institutional by nature, so one can imagine many variations on the basic theme. For concreteness, we develop a particular supply-and-demand story based on a set of investors who care about the current yield on their portfolios. When short-term rates are low, these investors reach for yield by purchasing long-term bonds, which pushes down long-term real forward rates and lowers the term premium. We then provide some evidence that is consistent with the existence of this reaching-for-yield channel.
According to the standard consumption-based asset pricing model, the expected excess return on long-term real bonds at time t is given by
First, it is possible that unexpected shifts in monetary policy could affect the volatility of bond returns [ ]. However, to explain our results using this mechanism, one would further need to argue that a surprise easing meaningfully lowers conditional volatility whereas a surprise tightening raises conditional volatility. Such an asymmetry seems difficult to motivate a priori and there is little evidence for it in the data.18
Second, shifts in monetary policy could impact [ ,-]. On the nominal side, Campbell, Sunderam, and Viceira (2012) argue that the correlation between inflation and the real SDF may vary over time, so this term could play a role in explaining time-variation in the inflation risk premium. It is less clear why the correlation between real bond returns and the real SDF would vary and, particularly, why it would vary meaningfully at high frequencies in response to FOMC announcements.
Finally, consider explanations that involve changes in -the mechanism that generates time-varying risk premia in most modern consumption-based models. These models, including habit formation (Campbell and Cochrane (1999)), long-run risks (Bansal and Yaron (2004)), or time-varying disaster risk (Gabaix (2011)), share a common reduced form:  is high during bad economic times and low during good times. However, in order for them to be relevant for our purposes, one would have to believe that changes in the stance of monetary policy actively cause-rather than simply respond to-changes in things like long-run disaster probabilities. This seems like something of a stretch.
An alternative explanation for why monetary policy can move term premia is based on supply-and-demand effects that operate in partially segmented bond markets.We illustrate this point with a simple model featuring a set of investors who care about the current yield on their portfolios. The key assumptions of the model are as follows. There are two dates, 1 and 2. The real log short rate at time 1, , is set by the central bank. The real log short rate at time 2, , is initially uncertain. Moreover, monetary policy is assumed to be neutral in the long run. Thus, both E and Var] are outside of the time-1 control of the central bank and should be thought of as pinned down by long-run macroeconomic fundamentals. The only endogenous variable is , the time-1 log yield on real long-term (i.e., 2-period) bonds, and our interest is in seeing how varies with the stance of monetary policy as summarized by .
A fraction a of investors are "yield-oriented" with non-standard preferences described below, while a fraction (1 - a) are "expected-return-oriented" with conventional mean-variance preferences. Both investor types have unit risk tolerance.
Expected-return-oriented investors have zero initial wealth and construct long-short positions to maximize E[w] - Var[w]/2, where w is their future wealth. If they purchase b units of long-term bonds and finance this position by rolling over short-term borrowing, their future wealth is .19 Thus, expected-return-oriented investors solve
By contrast, yield-oriented investors pick their holdings of long-term bonds b, to solve
We assume there is a fixed supply Q of long-term real bonds. The market clearing condition for long-term bonds is which implies that the equilibrium long-term forward rate is
The reaching-for-yield term in (16) and (17) is what enables the model to rationalize our prior findings, namely that an easing of monetary policy is associated with a decline in distant real forwards and a decline in the real term premium. When the central bank cuts the short rate, rises and the term premium falls. Intuitively, this is because yield-oriented investors are hungrier for current income when is low. As a result, they are willing to take on more duration risk by purchasing higher-yielding long-term bonds. And due to the limited risk tolerance of investors on the other side of the trade, this shift in demand lowers the term premium on these long-term bonds. Note that this explanation draws no distinction between movements in rates on FOMC versus non-FOMC days-it doesn't matter whether rates move due to news about the Fed's reaction function or news about macroeconomic fundamentals. Yield-oriented investors care about the differential carry from holding long-term bonds irrespective of its root cause.
Why, according to this view, would one expect this lower term premia to accrue largely over the following 12 months? There are a few possibilities. A first is that a decline in short rates only temporarily boosts demand for long-term Treasuries from yield-oriented investors. Perhaps some yield-oriented investors initially respond to a drop in short rates by taking on more duration risk, but over time they instead shift towards taking on more credit risk. Alternatively, if arbitrage capital moves slowly in response to changes in risk-adjusted returns, the demand shock from yield-oriented investors may be met with increased arbitrageur capital over time. Or, following Greenwood, Hanson, and Stein (2010), the increased demand for long-term bonds may be gradually accommodated by non-financial firms who adjust their debt maturity in response to shifts in investor demand. We attempt to shed some light on these issues below.
In addition to rationalizing the movements in real forward rates and term premia documented in Sections II and III, the model offers an additional set of predictions. Specifically, if we can identify a priori those investors who are most prone to be yield-oriented, their holdings of long-term bonds should be increasing in the yield spread. This follows immediately from equation (15), which says that the demand of yield-oriented investors is a function of .
Of course, the holdings of the investing public as a whole must equal the fixed supply of long-term bonds, so there must be other investors (e.g., broker-dealers or hedge funds) who care less about current yield differentials and more about expected returns, and who take the other side of the trade. In what follows, we use commercial banks as a proxy for yield-oriented investors and primary dealers as a proxy for expected-return-oriented investors. As explained below, the logic of this split is based on existing accounting conventions, which arguably should have the effect of making banks more concerned with current yield than dealers.
We use quarterly Call Report data on the duration of commercial bank security portfolios to test the hypothesis that banks act like the yield-oriented investors in our model. Several factors suggest that commercial banks may be prone to behave in a yield-oriented fashion. First, the vast majority of commercial banks (weighted by market value) are publicly traded, so bank managers with short horizons may be tempted to take actions that boost current reported earnings at the expense of longer-term earnings (see e.g., Stein (1989)). Second, due to GAAP accounting conventions, a bank can typically boost near-term accounting earnings simply by replacing low-yielding securities in its non-trading accounts with higher-yielding securities.20 This is because interest income on non-trading-account securities flows through the income statement, but unrealized gains and losses on such securities do not flow through net income. Thus, a desire to boost current reported profits could lead bank managers to invest more aggressively in long-term securities when the yield curve is steep. Finally, because GAAP earnings also drive changes in regulatory capital, a bank may be able to boost its capital ratios and generate regulatory slack in the near-term by engaging in a larger carry-trade when the curve is steep.
Given the coarse disclosure available in the Call reports, we focus on a crude measure of securities portfolio duration: the aggregate fraction of non-trading-account securities with a current remaining maturity (for fixed-rate securities) or next re-pricing date (for floating-rate securities) of one year or longer: . This measure is available beginning in 1988. Using quarterly data, we estimate specifications of the form
Table 6 presents the results from this exercise. Column (1) shows that there is a strong positive relationship between and .21 In terms of dollar magnitudes, the coefficient in column (1) suggests that a 100 basis-point decline in the short rate, holding fixed the long rate, leads to a 1.06 percentage-point increase in the share of bank securities that are long term. Bank securities have averaged roughly 18.5% of total bank assets since 1988. As of 2010:Q4, commercial bank assets were $11,728 billion, so this means that a 100-bp increase in the yield spread raises bank demand for long-term securities by $23 billion = 1.06%18.5%$11,728. So a 300-bp swing in the yield spread-roughly the range over a full easing cycle-would boost demand by $69 billion. Of course, the less-than-1-year versus longer-than-1-year margin is potentially only part of the overall portfolio adjustment process-banks might also be extending their duration within the longer-than-1-year bucket-and banks are just one set of investors who may care about current income. Thus, the results in Table 6 suggest that the induced shift in total demand from all yield-oriented investors could be quite substantial.
The remaining columns of Table 6 test another implication of the reaching-for-yield story. Specifically, if reaching for yield is partially driven by a desire to manage reported earnings, then this tendency should be more pronounced for publicly-traded banks than for privately-held banks. Of course, if reaching for yield is driven solely by a desire to boost capital ratios and maintain regulatory slack, then one would not expect to see much of a difference between public and private banks. To investigate this issue, we construct two versions of , one for public banks and another for private banks.22 As shown in column (2), the results for public banks are similar to those for all banks. This true almost by construction since a large majority of aggregate commercial banking assets are held by public banks. Consistent with the earnings-management hypothesis, column (3) shows that yield-chasing behavior is less pronounced amongst private banks. The coefficient of 0.674 on - for private banks in column (3) is only half of the corresponding coefficient for public banks in column (2). However, as shown in column (4), we cannot reject the hypothesis that the coefficient for public banks is the same that for private banks. Thus, the split between public and private banks goes in the direction predicted by the earnings-management story, but the evidence on this front is statistically weak. Moreover, the positive, albeit only marginally significant, coefficient for private banks suggests that a desire to maintain regulatory slack might also play some role.
Another question has to do with the persistence of the shifts in banks' demands for long-term bonds. We find some tentative evidence (not reported) suggesting that these demand shocks are gradually reversed over roughly the following 8 quarters. One way to see this is to add lagged values of to equation (18) and then examine the cumulative sum of coefficients on contemporaneous and lagged changes in the yield spread.
Next we examine the Treasury holdings of primary dealers. We think of primary dealers as a natural proxy for the expected-return-oriented investors in our model, the arbitrageurs who accommodate demand shocks coming from yield-oriented investors. Importantly, primary dealer activities are either housed within broker-dealers or in commercial bank trading departments. As a result, unlike banks' non-trading accounts, primary dealers operate entirely on mark-to-market accounting. So even if they wanted to manage their earnings, playing the term spread would be less of a sure thing for them.
We work with data from the Federal Reserve Bank of New York on the aggregate holdings of primary dealers. A key advantage of this data is that we have high frequency observations of dealer holdings by maturity. Specifically, each week from July 2001-present, we have data on the aggregate net (long minus short) dealer holdings of Treasury bills (all of which mature in less than one year) and nominal coupon-bearing Treasuries broken into four buckets by remaining maturity: shorter than 3 years, 3 to 6 years, 6 to 11 years, and longer than 11 years.23
Measuring the net duration of primary dealer positions is a bit tricky since dealers can be net short Treasuries, both in a given maturity bucket as well as overall. To deal with this complication, we compute
Obviously, a variety of factors besides those in our model might impact the duration of dealers' Treasury holdings. In an attempt to control for some of these, we include proxies for the weekly change in the scale of dealers' net positions in Treasuries, as well as the change in their net positions across all other reportable fixed income asset classes. A related concern is that high-frequency variation in the maturity structure of dealer positions may be driven by seasonal patterns of Treasury issuance-e.g., due to seasonal fluctuations in T-bill supply or the large offerings of longer-term notes and bonds in February, May, August, and November. To deal with this, we include a full set of week-of-year dummies in order to soak up any seasonal fluctuations in Treasury supply.
Using weekly data, we then estimate specifications of the form
Finally, we examine the dynamics of following a shock to the yield spread. Specifically, we separately estimate
Our theory of yield-oriented investors is one specific example of a supply-and-demand channel that connects monetary policy shocks to real term premia. However, one can tell other stories in a similar spirit. Hanson (2012) emphasizes time-variation in the aggregate supply of duration. Specifically, due to the negative convexity of mortgage-backed securities, the total quantity of duration risk that bond investors must bear increases when rates rise. If fixed-income markets are partially segmented from other asset markets, then this variation in aggregate duration could raise the term premium via a conditional-CAPM channel as in Vayanos and Vila (2009). The intuition is straightforward: if the supply of a given risk factor rises, the risk premium needs to rise in order to induce investors to hold the new supply. Hanson (2012) tests this alternative by using measures of aggregate fixed income duration to forecast bond returns.25 He finds that this duration-risk-premium channel appears to soak up some, but not all, of the explanatory power of recent changes in forward rates for future bond returns.
Changes in the stance of monetary policy have a surprisingly strong impact on distant forward real interest rates. These movements in forward rates appear to reflect changes in term premia, which largely accrue over the next year, as opposed to varying expectations about future real rates. Moreover, our evidence suggests that the driving force behind time-varying term premia is the behavior of yield-oriented investors, who react to a cut in short rates by increasing their demand for longer-term bonds, thereby putting downward pressure on long-term rates.
Our work raises, but does not answer, a series of questions about the ultimate economic importance of this monetary transmission channel. In particular, suppose that a monetary easing lowers long-term real rates through the mechanism we have described. What might the resulting impact on corporate investment be? On the one hand, the fact that the effect of monetary policy on long-term real rates is transitory (i.e., it is reversed after about a year) might seem to imply that it would matter less for corporate capital budgeting decisions. On the other hand, some firms may view the temporarily lower long-term rates as a market-timing opportunity, i.e., a window during which it is particularly attractive to issue long-term debt. This in turn could serve to stimulate their investment.26
While we have focused narrowly on term premia in the Treasury market, the idea that monetary policy can influence bond-market risk premia has potentially broader implications. Indeed, much recent work has been motivated by the hypothesis that accommodative monetary policy can reduce credit-risk premia.27 It seems like a promising avenue for future work would be to study these two channels of monetary transmission in a unified setting. For example, in the context of our model, one could allow yield-oriented investors to choose among not only short-term and long-term Treasuries, but defaultable credit instruments (corporate loans, mortgages, etc.) as well. This would presumably yield a set of predictions about the co-movement of term premia and credit-risk premia in response to changes in monetary policy, and could be the basis for a wider-ranging and more integrated empirical investigation of these phenomena.
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Figure 1: Response of US forwards to monetary policy news on FOMC days. Panel A plots the coefficient (n) from estimating equation (4a) on FOMC announcement dates from 1999 through February 2012 (which refer to as the "present" throughout the paper)
Panel A: Response of nominal forwards by maturity
Panel B: Response of real and break-even inflations forwards by maturity
Figure 2: Response of UK forwards to monetary policy news on BOE days. Panel A plots the coefficient (n) from estimating equation (4a) on BOE MPC announcement dates from 1999-present
Panel A: Response of nominal forwards by maturity
Panel B: Response of real and break-even inflations forwards by maturity
Figure 3: Impulse response of 10-year US forwards to short-term nominal rates. Panel A plots the coefficient b(k) from estimating equation (9) using all days from 1987-present
Panel A:Nominal forwards, 1987-present, All days
Panel B:Nominal forwards, 1987-present, FOMC only
Panel C:Real forwards, 1999-present, All days
Panel D:Real forwards, 1999-present, FOMC only
Figure 4: Impulse response of primary dealer NETDUR to the yield spread. The figure plots the coefficient b(k) from estimating the following regressions using weekly data from July 2001- present
Table 1: Response of US Treasury forward rates to monetary policy news. Regressions of changes in nominal, real, and breakeven inflation instantaneous forward rates (X = $, TIPS, and p) on changes in the 2-year nominal yield on FOMC announcement days from 1999 through February 2012 (which refer to as the "present" throughout the paper)
http://www.federalreserve.gov/pubs/feds/2006/200628/200628abs.html and http://www.federalreserve.gov/pubs/feds/2008/200805/200805abs.html .
Table 2: Robustness checks for US. Regressions of changes in nominal, real, and breakeven inflation instantaneous forward rates (X = $, TIPS, and p) on changes in various short rates on FOMC announcement days
|Baseline: 2-year UST||107||0.446||[3.54]||0.09||0.421||[4.63]||0.18||0.025||[0.23]||0.00|
|Vary proxy for MP news: 2-year UST, 1-day change||107||0.245||[2.98]||0.08||0.215||[2.90]||0.13||0.021||[0.30]||0.00|
|Vary proxy for MP news: 1-year UST||107||0.186||[1.30]||0.01||0.287||[2.60]||0.07||-0.100||[-0.89]||0.01|
|Vary proxy for MP news: 1-year UST, 1-year forward||107||0.505||[5.13]||0.17||0.408||[5.42]||0.24||0.097||[1.14]||0.02|
|Vary proxy for MP news: 3-quarter forward Eurodollar||107||0.239||[2.39]||0.07||0.286||[4.43]||0.20||-0.046||[-0.66]||0.01|
|Vary proxy for MP news: 6-quarter forward Eurodollar||107||0.398||[4.23]||0.23||0.326||[6.33]||0.33||0.072||[0.95]||0.02|
|Vary proxy for MP news: 9-month forward Fed funds||89||0.258||[1.85]||0.03||0.354||[3.72]||0.11||-0.096||[-0.82]||0.01|
|Vary proxy for MP news: 12-month forward Fed funds||74||0.308||[1.90]||0.04||0.401||[3.42]||0.14||-0.093||[-0.75]||0.01|
|Vary proxy for MP news: 1-year OIS||81||0.172||[0.84]||0.01||0.334||[2.15]||0.07||-0.162||[-1.07]||0.02|
|Vary proxy for MP news: 2-year OIS||80||0.571||[3.53]||0.12||0.595||[5.24]||0.25||-0.024||[-0.19]||0.00|
|Vary proxy for MP news: 1-year OIS, 1-year forward||80||0.570||[5.48]||0.21||0.517||[7.32]||0.33||0.052||[0.60]||0.01|
|Vary proxy for MP news: GSS (2005b) "path" factor||107||0.274||[2.43]||0.10||0.279||[3.75]||0.23||-0.005||[-0.07]||0.00|
|Vary sample Add 5 QE dates||112||0.504||[3.30]||0.10||0.455||[4.97]||0.18||0.049||[0.40]||0.00|
|Vary sample Regular meeting||100||0.452||[4.16]||0.09||0.383||[4.04]||0.14||0.069||[0.73]||0.01|
|Vary sample Unscheduled meeting||7||0.565||[2.62]||0.38||0.668||[3.66]||0.67||-0.103||[-0.38]||0.02|
|Vary sample Add minutes dates||212||0.528||[5.85]||0.17||0.312||[4.76]||0.14||0.203||[2.04]||0.04|
Table 3: Response of UK gilt forward rates to monetary policy news. Regressions of changes in nominal, real, and breakeven inflation instantaneous forward rates (X = $, TIPS, and p) on changes in the 2-year nominal gilt yield on MPC announcement days from 1999-present
Table 4: Response of US long-term forward rates to changes in short-term rates. Regressions of changes real instantaneous forward rates on changes in short-term nominal rates on all days, allowing for a differential response on FOMC announcement dates (excluding any QE dates)
|FOMC [Standard Error]||[-0.26]||[-0.58]||[-1.20]|
|Constant [Standard Error]||[-0.61]||[-0.38]||[-0.23]|
Table 5: Mean reversion in forward rates. This table forecasts 12-month changes in forward rates using changes in forward rates over the past 3 months
Panel A: Forecasting changes in nominal forward rates, 1987-present
|(1) OLS||(2) IV||(3) OLS||(4) IV||(5) OLS||(6) IV||(7) OLS||(8) IV|
|Constant [Standard Error]||[-2.76]||[-2.59]||[0.37]||[-0.19]||[-2.78]||[-2.61]||[0.37]||[-0.21]|
Panel B: Forecasting changes in real forward rates, 1999-present
|(1) OLS||(2) IV||(3) OLS||(4) IV||(5) OLS||(6) IV||(7) OLS||(8) IV|
|Constant [Standard Error]||[-2.85]||[-2.70]||[1.54]||[1.44]||[-2.88]||[-2.70]||[1.49]||[1.39]|
Table 6: Duration of commercial bank securities portfolios and the yield spread, 1988-2010. Regressions of quarterly changes in the aggregate duration of bank securities portfolios on quarterly changes in the yield spread
|All Banks (1)||Public Banks (2)||Private Banks (3)||Difference:Public - Private (4)|
|Constant [Standard Error]||[0.08]||[0.02]||[-0.07]||[0.07]|
Table 7: Duration of primary dealer Treasury holdings and the yield spread, 2001-present. Regressions of weekly changes in the aggregate duration primary dealer Treasury holdings on weekly changes in the yield spread
|Treasury Holdings (1)||Treasury Holdings (2)||Treasury plus Agency Holdings (3)||Treasury plus Agency Holdings (4)|
|Constant [Standard Error]||[0.12]||[-0.94]||[0.17]||[-0.84]|