Rate Conundrums in the 21 st Century ∗

A large literature argues that long-term nominal interest rates react far more to high-frequency (daily or monthly) movements in short-term rates than is predicted by the standard expectations hypothesis. We find that, since 2000, this high-frequency sensitivity has grown even stronger in U.S. data. By contrast, the association between low-frequency changes (at 6or 12-month horizons) in shortand long-term rates, which was equally strong before 2000, has weakened substantially. As a result, “conundrums”—defined as 6or 12-month periods in which short and long rates move in opposite directions—have become increasingly common. We show that this post-2000 combination of high-frequency “excess sensitivity” and low-frequency “decoupling” of shortand long-term rates arises because increases in short rates temporarily raise the term premium on long-term bonds, leading long rates to temporarily overreact to changes in short rates. This post-2000 phenomenon can be understood using a model in which (i) declines in short rates lead to outward shifts in the demand for long-term bonds—e.g., because some investors “reach for yield”—and (ii) the arbitrage response to these demand shifts is slow. We discuss the implications of our findings for the transmission of monetary policy and the validity of the event-study methodology. ∗We thank John Campbell, Gabriel Chodorow-Reich, Richard Crump, Thomas Eisenbach, Robin Greenwood, Eric Swanson, Jeremy Stein, and Adi Sunderam as well as seminar participants at the 2018 AEA meetings, Johns Hopkins University, the Society for Computational Economics 2017 International Conference, University of Georgia, and University of Southern California for helpful comments. Hanson gratefully acknowledges funding from the Division of Research at Harvard Business School. All errors are our sole responsibility. The views expressed here are the authors’ and are not representative of the views of the Federal Reserve Bank of New York or of the Federal Reserve System. Emails: shanson@hbs.edu; david.lucca@ny.frb. org; wrightj@jhu.edu. Short-term nominal interest rates are determined by current monetary policy and its near-term expected path. Shocks to monetary policy and the macroeconomy are generally seen as being short-lived, so long-term rates should not be highly sensitive to changes in short rates if the expectations hypothesis holds (Shiller, 1979). However, a large literature demonstrates that long-term nominal rates are far more sensitive to high-frequency changes in short rates than is predicted by this standard view combining fast mean-reversion in short rates with the expectations hypothesis (Shiller et al., 1983; Cochrane and Piazzesi, 2002; Gürkaynak et al., 2005). Despite its importance for monetary policy transmission, the deeper forces underpinning this puzzling degree of high-frequency sensitivity—and the extent to which this sensitivity has evolved over time—remain poorly understood. In this paper, we document an important and previously unrecognized fact about the term structure of nominal interest rates: the association between high-frequency changes (at daily or 1-month horizons) in shortand long-term rates has strengthened considerably since 2000. In contrast, the relationship between low-frequency changes (at 6or 12-month horizons) in shortand long-term interest rates, which was also quite strong before 2000, has weakened substantially in recent years. Concretely, between 1971 and 1999, a daily regression of changes in 10-year U.S. Treasury yields on changes in 1-year yields delivers a coefficient of 0.56; and the analogous regression using 12-month changes gives the same coefficient of 0.56. Strikingly, between 2000 and 2017, the coefficient from the daily regression jumps to 0.86, while the coefficient from the corresponding 12-month regression drops to just 0.20. In summary, changes in U.S. shortand long-term rates have become even more tightly linked at high frequencies since 2000, but have largely decoupled at low frequencies.1 And, we find broadly similar patterns for Canada, Germany, and the U.K. A stark example of such low-frequency decoupling was the period after June 2004 when the Federal Reserve raised its short-term policy rate, but longer-term yields fell. This was famously described by then Federal Reserve Chairman Greenspan as a “conundrum,” and has been discussed in many papers, including Backus and Wright (2007). One way to summarize our key finding is that we show that this 2004 episode was by no means unique: “conundrums” —defined as 6or 12-month periods where short and long-term rates move in opposite directions—have become far more common since 2000. From 1971 to 1999, 1-and 10-year nominal yields moved in the same direction in 82% of all 6-month periods. By contrast, since 2000, the corresponding figure has only been 62%. What explains the puzzling post-2000 tendency of shortand long-term rates to move together at Because of the importance of communication about the near-term path of monetary policy, we take the short rate to be the 1-year nominal Treasury yield rather than the overnight federal funds rate targeted by the Federal Reserve.