Vítor Constâncio: Understanding the yield curve
Opening address by Mr Vítor Constâncio, Vice-President of the European Central Bank, at
the ECB workshop "Understanding the yield curve: what has changed with the crisis?",
Frankfurt am Main, 8 September 2014.
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Ladies and gentlemen,
It is a great pleasure for me to welcome you on behalf of the Executive Board of the
European Central Bank to this topical workshop on "Understanding the yield curve: what has
changed with the crisis?". This event is part of a sequence of very productive workshops on
asset pricing that have been jointly organised by the ECB and the Bank of England for
several years now. I am very pleased to see this established practice of collaboration across
our two central banks continuing and gaining further ground.
I would also like to welcome all participants: colleagues from other central banks, among
them many from the Federal Reserve System and from the co-organising Bank of England,
the participants from academia, guests from the private sector and colleagues from the
European Central Bank.
In my remarks today, I will first give a short overview of the role of the yield curve in monetary
policy deliberations, mentioning also the impact of the crisis. I will then go on to talk about
some topical and much discussed issues that are related to the challenges central banks
face in interpreting the information coming from fixed income markets.
The role of the yield curve in monetary policy deliberations
As we all know, the understanding of the dynamic evolution and the forecasting of the yield
curve has many practical applications: pricing asset and derivatives, devising strategies for
public debt programs, managing risk and conducting monetary policy. An old simple use of
the yield curve, more common in the US, was to use its slope to forecast recessions. In
2009, Rudebusch and Williams1 published a paper about what they call "the puzzle of the
enduring power of the yield curve" to forecast recessions. In 2006, when the US yield curve
got inverted predicting a recession, the whole idea was dismissed as having finally failed only
to be confirmed by the Great Recession. In a very recent paper, Chinn and Kucko2 examine
the issue for the US, the euro area and eight European countries. The results show that the
slope indicator performance has deteriorated in recent years although it seems to work better
than other leading indicators for some European countries.
Today we are mainly interested in examining the important role the yield curve has for the
conduct of monetary policy.
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
longerterm 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
riskfree rate. Should we use Bund yields, euro area average AAA rates or OIS rates, or does it
depend on the matter at hand?
Incidentally, an intriguing question in a currency union is the following: if it is difficult to
identify a risk-free rate in a currency union, this means that there is no risk-free asset either,
besides the central bank's own liabilities, the currency. Whether this peculiar situation adds
to the challenges facing the central bank of a monetary union, in terms of signal-extraction
and analysis of expectations, I leave to you as a topic for reflection.
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.
It is well known that during decades the fields of finance and macroeconomics dealt with
interest rates, asset prices and the yield curve in a total different way and without much
interaction. As Diebold and Rudebusch point out in their book published last year on "Yield
curve modelling and forecasting":3 "In macro models, the entire financial sector is often
represented by a single interest rate with no accounting for credit or liquidity risk and no role
for financial intermediation or financial frictions. Similarly, finance models often focus on the
consistency of asset prices across markets with little regard for underlying macroeconomic
fundamentals. To understand important aspects of the recent financial crisis ... a joint
macrofinance perspective is likely necessary".
The macro-finance approach to the analysis of the yield curve had several developments
even before the crisis. In 2006, Hördahl, Tristani and Vestin,4 (the last two, ECB
researchers), published a paper embedding the analysis of the term structure of interest
rates into a DSGE model. With a few changes in the standard framework of the time, they
were able to replicate key features of the term structure usually present in the data. Diebold,
Rudebusch and Aruoba, also in 2006,5 provided a bidirectional connection between the
factors of a dynamic Nelson-Siegel model of the yield and macro variables. The first factor,
the level, showing a high correlation with inflation and the second factor, the slope, being
highly correlated with real economy activity. Later, in 2007, Rudebusch and Wu6 developed a
macro-finance model with a no-arbitrage dynamic specification of the term structure and a
small new Keynesian model. In an application of this model to the great moderation period,
they find the level factor associated with the perceived inflation target of monetary policy and
the slope factor connected with the cyclical response of monetary policy with the economy.
The field of macro-finance continued to expand and recently focused on how to consider the
zero lower bound into yield curve models and we have an example of that research in our
workshop.
Current policy questions
Judged in terms of the number of policy questions, this is an excellent time to be doing
research on yield curves. Yields in the euro area have recently fallen to record lows. Does
this reflect the underlying fundamentals in the euro area, the expectation of additional
monetary loosening, or some kind of mispricing by markets? What is the risk that yields could
suddenly snap back to much higher levels?
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. 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?
The workshop papers and concluding remarks
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.
We are also pleased to welcome two keynote speakers from the US, Gregory Duffee and
Glenn Rudebusch, who are both leading researchers in the literature, representing academia
and the Federal Reserve System, respectively. Both will talk about the influence of
unconventional monetary policy on the yield curve and it will be enlightening to hear their
perspectives on the subject.
Finally, we have a distinguished panel of market experts, who have been primed to talk to
some of the issues I have mentioned, followed by a Q & A, which should ensure that the
workshop ends on a high note.
These are the reasons that make almost superfluous my wish for some stimulating
discussions over the next day and a half and a very productive workshop.
Thank you for your attention.