Monetary policy implications of volatility linkages among long-term interest rates

This paper investigates the implications for monetary policy from the increasing integration of capital markets using interest rates. The methodology is a multivariate EGARCH model, which captures the spillover mechanism across markets. The results indicate that since 1990 there have been stronger volatility linkages among markets. Evidence that globalization has influenced the behavior of interest rates is suggested from the way disturbances in a market spill over to other markets, thereby affecting the monetary policy conduct in all markets. As investors now have more information about global bonds, their concerted actions generate more volatility as they continuously rebalance their portfolios.     

International real interest rate equalization. A multivariate time-series approach

This paper investigates the dynamic behaviour of monthly ex post real interest rates from several countries over the period 1980 to 1991. It is found that real interest rates are stationary over this period and that deviations from real interest parity are significant in the short run but disappear in the long run. The latter evidence is established using the concept of co-dependent time series proposed by Gourieroux and Peaucelle (1989) for the analysis of multivariate stationary time series.     

Forecasts of US short-term interest rates: A flexible forecast combination approach

This paper develops a flexible approach to combine forecasts of future spot rates with forecasts from time-series models or macroeconomic variables. We find empirical evidence that, accounting for both regimes in interest rate dynamics, and combining forecasts from different models, helps improve the out-of-sample forecasting performance for US short-term rates. Imposing restrictions from the expectations hypothesis on the forecasting model are found to help at long forecasting horizons.     

Budget deficits and real interest rates: a regime-switching reflection on Ricardian Equivalence

This paper investigates the relevance of the Ricardian Equivalence theorem for the relationship between the budget deficit and real interest rate. In contrast to the existing literature, we focus on regime-change over a long study period and consider nonlinearities. Using a Markov regime-switching model applied to two centuries of annual data, we find evidence that the US economy switches between a Ricardian Equivalence regime, characterized by an insignificant relationship between the adjusted primary budget deficit and real long-term interest rate, and a regime characterized by the traditional view of a positive relationship. We also find evidence that the transition probabilities between regimes are time-varying insofar as a weaker level of economic activity, a lower real interest rate differential between the US and abroad, or higher national debts, is associated with a weaker relationship between budget deficits and interest rates.     

The time-varying behaviour of real interest rates: a re-evaluation of the recent evidence

A time-varying parameter model with Markov-switching conditional heteroscedasticity is employed to investigate two sources of shifts in real interest rates: (1) shifts in the coefficients relating the ex ante real rate to the nominal rate, the inflation rate and a supply shock variable and (2) unconditional shifts in the variance of the stochastic process. The results underscore the importance of modelling continual change in the ex ante real rate in terms of other economic variables rather than relying on a statistical characterization that permits only a limited number of discrete jumps in the mean of the process. Copyright © 1999 John Wiley & Sons, Ltd.     

What do interest rates reveal about the functioning of real business cycle models?

This paper begins by documenting the extent to which the predictions of standard Real Business Cycle (RBC) models are incompatible with observed movements in real interest rates. The main finding of the paper is that extending the baseline model to include habit persistence in consumption and adjustment costs to capital significantly improves the model's empirical performance. In our evaluation of the model's performance, we take special care of estimating and testing predictions of the model using both moments drawn directly from the data and moments calculated after identifying shocks to the stochastic trend.     

The impact ofThe Wall Street Journal’s closely watched reports on short-term interest rates

Using a reduced-form macroeconomic model, suggested by the Real Economic Activity hypothesis, in this study the authors examine the effect of certain economic indicators, published weekly byThe Wall Street Journal, on interest rates, for the period November 1987–November 1989. The results suggest that unexpected M3 announcements significantly affect market interest rates. However, there is no evidence of significant announcement effects for the other government statistics (new jobless claims, auto sales, M1, and M2). The evidence suggests that financial markets have not considered information in these economic announcements to be particularly newsworthy, in the face of M3 announcements.     

Testing the stabilization hypothesis in the UK short-term interest rates: Evidence from a GARCH-X model

The objective of this paper is to examine the validity of one of the recurring arguments made against futures markets that they give rise to price instability. The paper concentrates on the impact of futures trading on the spot market volatility of short-term interest rates. The analytical framework employed is based on a new statistical approach aiming to reconcile the traditional models of short-term interest rates and the conditional volatility processes. More specifically, this class of models aims to capture the dynamics of short-term interest rate volatility by allowing volatility to depend on both scale effects and information shocks. Using a GARCH-X and asymmetric GARCH-X model four main conclusions emerge from the present study. First, the empirical results suggest that there is an indisputable change in the nature of volatility with evidence of mean reversion after the onset of futures trading. Second, the information flow into the market has improved as a result of futures trading. Third, a stabilization effect has been detected running from the futures market to the cash market by lowering volatility levels and decreasing the risk in the spot market. Finally, trying to capture the leverage effect the findings suggest that positive shocks have a greater impact on volatility than negative shocks.     

Stochastic interest rates under rational inattention

This paper introduces state uncertainty due to information-processing constraints into the Vasicek model to examine the impacts of rational inattention. By exploiting the term structure of interest rates, we derive closed-form solutions for the subjective bond price and the corresponding bond yield and find that uncertainty induced by informational frictions plays vital roles in undervaluing the bond price and overestimating the bond yield. Furthermore, we clarify the applications of interest rate dynamics under rational inattention and generate the following results: (i) there is an ambiguous relationship between the investor’s channel capacity and option price; (ii) an increase in state uncertainty via a change in the degree of channel capacity is likely to accelerate investment.     

Forecasting interest rates with shifting endpoints

We consider forecasting the term structure of interest rates with the assumption that factors driving the yield curve are stationary around a slowly time‐varying mean or ‘shifting endpoint’. The shifting endpoints are captured using either (i) time series methods (exponential smoothing) or (ii) long‐range survey forecasts of either interest rates or inflation and output growth, or (iii) exponentially smoothed realizations of these macro variables. Allowing for shifting endpoints in yield curve factors provides substantial and significant gains in out‐of‐sample predictive accuracy, relative to stationary and random walk benchmarks. Forecast improvements are largest for long‐maturity interest rates and for long‐horizon forecasts. Copyright © 2013 John Wiley & Sons, Ltd.     

Nominal interest rate policy rules and the feasibility of real interest rate control

In this paper the author builds a financial market model to demonstrate that policy aimed at reducing the variance in nominal interest rates reduces the information content of these variables. This has the undesirable effect of destabilizing real interest rates. The researcher demonstrates that nominal interest rate policy rules stabilize the component of the variance in the ex ante real interest rate attributable to the variance in the nominal rate. The variability of the expected inflation rate can, however, be increased by such policy rules, making the net effect of a nominal interest rate policy on the variance in the real interest rate ambiguous.     

The behavior of real exchange rates

Dominating the behavior of real exchange rates for the dollar during the course of the past two and a half decades have been two substantial and for many countries largely offsetting movements. In the years surrounding the breakdown of Bretton Woods most exchange rates fell precipitously and throughout the 1970s remained low. Near the start of the 1980s they began a rise that continued more or less unabated until early 1985. Any explanation of exchange rate behavior over this period, therefore, has to account for both of these movements, not simply the increase in real exchange rates for the dollar in the 1980s that has been the topic of so much discussion in the financial press. The explanation offered in this paper attributes these movements to the two important changes in monetary policy that occurred during these years.     

Optimal dividend policy with random interest rates

Several recent papers have studied the impact of macroeconomic shocks on the financial policies of firms. However, they only consider the case where these macroeconomic shocks affect the profitability of firms but not the financial markets conditions. We study the polar case where the profitability of firms is stationary, but interest rates and issuance costs are governed by an exogenous Markov chain. We characterize the optimal dividend policy and show that these two macroeconomic factors have opposing effects: all things being equal, firms distribute more dividends when interest rates are high and less when issuing costs are high.     

Time-frequency co-movements between oil prices and interest rates: Evidence from a wavelet-based approach

This paper investigates time–frequency co-movements between crude oil prices and interest rates. To test this relationship, the study applied a continuous wavelet and cross wavelet approaches to data from West Texas Intermediate (WTI) crude oil prices and interest rates in the United States (U.S.). Results from the sample period revealed significant relationships, in the intermediate term, between WTI crude oil prices and U.S. interest rates. Moreover, co-movements between oil price and interest rate variables were especially sensitive during abnormal political events and periods of financial ‘meltdown’. We further use Partial Wavelet Coherence (PWC) and Multiple Wavelet Coherence (MWC) methods to investigate the impacts of five major control variables namely GDP growth, unemployment, three-month Treasury bill, CPI index and industrial production index. The results show a powerful impact of control variables on oil-interest rates co-movements under different frequencies. Finally, we show evidence of co-integrating long run relationship between oil markets and control variables. These results have important implications for energy investors and policy makers.     

Higher interest rates should not unduly faze consumers

• ? Though the MPC has signalled a more aggressive pace of interest hikes than previously anticipated, we still expect the impact on the consumer sector in aggregate to be modest. We estimate that household debt servicing costs will rise from the current level of 4.1% of household income to 5.0% by the end of 2019. This would still be only a little over half the pre‐crisis peak.
• ? We expect the MPC to hike interest rates twice in both 2018 and 2019, taking Bank Rate to 1.5% by the end of next year. Higher interest rates will impact on consumer spending by increasing debt servicing costs and reducing the attractiveness of credit (including mortgages), but savers will benefit from higher returns on their deposits.
• ? Mortgages account for 77% of loans to UK households and full pass through of a 100bp rise in Bank Rate to variable rate loans, implying an increase from 2.78% to 3.78%, would add £100 a month to the cost of servicing an average mortgage. But only two‐fifths of borrowers have a variable rate deal, so for many homeowners the adjustment to higher interest rates will not be immediate. And the proportion of houses which are owned via a mortgage has fallen over the past decade, suggesting that the household sector as a whole will be less sensitive to higher mortgage interest rates.
• ? Historically the relationship between Bank Rate and interest rates on unsecured lending has been weak and rates on credit cards and personal loans have not yet risen following November's rate hike. The link to deposit rates has been stronger and higher returns on savings will mitigate some of the damage to household income from higher debt servicing costs, although uneven distribution of debt and savings means that there will be winners and losers at a more disaggregated level.
• ? We have used the Oxford Economics Global Economic Model to run a counterfactual scenario where Bank Rate is kept at 0.5% throughout 2018 and 2019. The results suggest that the pace of rate hikes assumed in our baseline forecast would reduce the level of consumer spending by 0.2 percentage points by the end of 2019.

     

Pricing perpetual options with stochastic discount interest rates

The aim of this study is to investigate the prices and optimal exercise strategies of certain perpetual American options on the asset under stochastic discount interest model. This is different from Gerber and Shiu (N Am Actuar J 2(3):101–112, 1998), in which the interest force was a constant; here we suppose that the accumulated interest function is perturbed by the standard Brownian motion and Poisson process. We obtain an explicit expression of optimal option-exercise boundary in the case of perpetual put option. Moreover, we get a corresponding result when the individual claim is described by an exponential distribution. Finally, we analyze the influence of certain coefficients in stochastic interest model on the optimal option-exercise boundary.     

Predictions of short-term rates and the expectations hypothesis

This paper emphasizes that traditional tests of the EH are based on two assumptions: the expectations hypothesis (EH) per se and an assumption about the expectations generating process (EGP) for the short-term rate. Arguing that conventional tests of the EH need to assume EGPs that may be significantly at odds with the true EGP, we investigate this possibility by analyzing the out-of-sample predictive performances of several models for predicting interest rates, including a few models which assume that the EH holds in its functional form that relates long- to short-term yields. Using US riskless yield data for a 1970–2016 monthly sample and testing methods that take into account the parameter uncertainty, the null hypothesis of an equal predictive accuracy of each model relative to the random walk alternative is hardly ever rejected at intermediate and long horizons. This confirms that, at least at a practical level, the main difficulty with the EH is represented by the effective prediction of short-term rates. We discuss the relevance of these findings for central banks’ use of forward guidance.     

Fixed versus floating: vulnerability to rising interest rates

• ? Looking at different economies' exposure to fixed‐ and floating‐rate private‐sector debt reveals how vulnerable they could be to rising interest rates. Our analysis finds that Hong Kong, Sweden, China and Australia are potentially most exposed via floating rates to rising debt service costs. A 150bp rise in rates would also push several other countries' debt service ratios above the peaks of 2008. Less vulnerable economies include the US and Germany.
• ? High levels of floating‐rate debt imply a large and rapid pass‐through of rising interest rates to firms and households, with negative consequences. Exposure to floating‐rate debt as a share of GDP varies greatly: the highest levels are in Hong Kong, China, Sweden, Australia and Spain, with the lowest levels in the US, France and Germany.
• ? Growing shares of fixed‐rate housing debt in the US, Eurozone and UK mean the impact of higher interest rates may be less severe than a decade ago. Private deleveraging in countries such as the US, UK and Spain could also soften the impact.
• ? A rise of 100bp in short‐term interest rates would raise the debt service ratio after one year by around 2.5% of GDP in Hong Kong, with increases of 1.5–1.7% of GDP in Sweden, China and Australia. The smallest effects would be in the US and Germany.
• ? A 100–150bp rate rise would push debt service ratios in China, Hong Kong, Canada, France and the Netherlands well above their peaks of a decade ago. A similar rate rise would take debt service ratios in Sweden, South Korea and Australia close to, or above, previous peaks.
• ? The distribution of debt within economies, which our analysis does not cover, is also important. For example, there is some evidence that the US corporate sector has a high concentration of debt among borrowers with weak finances. Countries that are highly vulnerable to interest rate rises may see their central banks normalise policy rates more slowly than they otherwise would.