Monetary policy and the term structure of interest rates

Monetary policy

The prices of short term treasuries, the 3 months t-bills are set by the central banks. Central
banks use this interest rate as the main tool to conduct monetary policy. When they set interest
rates, they actually define a target for the three months t-bills rate. Central banks achieve this
target by using different tools, but in particular by operating in the overnight interbank market.

The prices of treasury bonds with maturities longer than three months, and therefore their
returns, are instead normally freely set by the market. The most important and liquid maturity is
the ten year one, but also three, five or thirty years maturities are normally quite liquid. Although
the prices of long-term bonds are set by the market, they are influenced by those of the shorter
term t-bills. Although set by the market, the yields of long-term bonds are therefore always
influenced by the choices of the central banks.

In certain circumstances central banks also purchase directly long-term bonds. This policy,
which is unconventional, is now called Quantitative Easing. Long-term rates are important
because they are the one that affect more the investment choices of firms. When normal tools
are ineffective central banks rely on QE, in normal conditions they use a policy tool called the
Taylor rule.

The central bank defines an ideal interest rates that it consider neutral in terms of price stability.
When the rate is set at this level the prices of goods should remain stable, according the models
that central banks follow. The central bank will set a different rate, whenever it desires to
impose a downward or upward shock on the path of the prices of goods. This occurs when the
variables that the central banks set are out of the targets.

The central bank sets targets on two variables, inflation and output gap. The central banks
works on the basis of an inflation target that it has to achieve and sets the interest rates to
compensate any deviation of inflation from the target. But at the same time the central bank
response to deviation of output from its long-term target, the so called output gap. When the
output gap is below trend, in fact, unemployment emerges and the central bank sets interest
rates that are low enough to stimulate investment and reduce unemployment. The two targets
are normally not in contrast as the two variables are affected by same cycle.

In maths:

where iN is the neutral interest rate, Π is the current level of inflation, Π¯ is the inflation target, Y
measures output growth, Y¯ is the long-run trend of output growth. α e β measure the
responses of the central bank to, respectively, inflation and output gap.

The term structure of interest rates

In line with most theories of the last decades, we now assume that economic agents make
rational expectations. This assumption involves that agents make use of all the information
available to forecast the behave of relevant variables. If central banks are credible, market
participants will make expectations regarding future short-term interest rates that are coherent
with the announced plans of the central bank. Central banks in fact, typically announce a path
for their future choices, they do not want to generate shocks unless it’s necessary.

In this case therefore the returns on longer term bonds should be coherent with the
expectations regarding the short-term rates that will be set in the future. When these conditions
are respected long-term interest rates thus provide information regarding market’s expectations
regarding future rates. However, market expectations can differ from the what announced by
the central bank, because markets need to assess the probability that new information will push
the central bank to change path.
The term structure of interest rates maps the returns of treasury bonds according to their
different maturities. We define with Rt,t+k the gross interest rate promised by a bond purchased
a time t and with maturity t + k, where Rt,t+k = 1 + rt,t+k . The term structure of interest rates
maps graphically rt,t+k as a function of the maturity k. The interest rates we consider are spot
rates.

Future contracts exist for interest rates as for other securities, commodities and exchange rates.
In the case of futures the interest rates are defined by contracts that are written now but regard
and must eb sttled at a future date. We define with R0,t1,t2 the gross interest rate promised by
a bond purchased a time 0 that will begin its life at time 1 and with maturity at time 2, where
R0,t1,t2 = 1 + r0,t1,t2 . Since future contracts are written at the same time as spot contracts,
these two sets of contracts, even if implying different maturities and timings of the cash flows,
they are based on the same information set.

Hence, the return that can be obtained from a long-term bond must the be the same as the one
that can be achieved by reinvesting sequentially the returns of shorter term bonds using futures:

La term structure

Equations (3) allows to understand the factors that influence the slope of the yield curve. The
long-term rate is in fact an average between the short and the future rates. Therefore, if the
yield curve displays a positive slope, it follows that term rates (future ones) are higher than the
current ones:

r0,t2 > r0,t1 => r0,t1,t2 > r0,t1 . (4)

In the presence of future contracts all of this only requires that agents make arbitrages in
financial markets, a very mild assumption.
The term structure of interest rates

Future contracts, however, not always exist, particularly for longer maturities. If the future rate
does not exist, we cannot obtain the long one as an average like before. The expectation theory
assumes that the return on long term bonds depend exclusively from the expectations of future
short-term ones. If this theory holds, then we can infer the implicit value of the expected future
rate from the difference between the two rates:

The same argument can of course be extended to longer maturities, but it becomes more likely
that other factors infleunce the longer-term returns. The expectation theory have found some
substantial empirical evidence supporting the main predictions. For example, we have evidence
that variations in short and long-run rates are normally in the same direction, as implied by the
theory. However, the theory does consider the possibility that long-term returns may involve a
premium to compensate for the risk of future variations of the short-run rates.

If investors are risk averse the could require a premium to cover this risk and this premium
should be proportionally larger as the maturities become longer. With longer maturities, in fact,
investors are locked in for a longer period by their previous choices. If future rate will be lower
than currently expected, holder of long-term bonds will benefit, bu they will lose in the opposite
case. The higher the uncertainty regarding the future path of short-term rates, the higher the
risk-premium that rational risk-averse investor should require.

In this case a risk premium rpn increases the return of the long-term bond beyond the expected
compounded return from rolling over shorter term bonds:

A competing theory, the preferred habitat theory suggests instead that short and long-term bond
markets are not bought by the same investors arbitrages not necessarily take place. According
to the theory, institutional factors may constrain large classes of investors.

In this case a large share of investors would prefer short term bonds because of risk aversion.
But at the same time institutional investors such as insurance companies need to invest long-
term to match the maturity of their liabilities that are very long-term in nature. When this is the
case, a liquidity premium may be requested by any class of agents to purchase bonds with
maturities different from the desired ones. These alternative theories, however, are not
necessarily in contrast with the expectation theory and they can be considered as refinements
of the basic theory that is extended to account for additional risk factors.

Starting from the basic expectation theory, a large literature has in recent decades explored with
sophisticated econometric techniques several extensions of the basic model. We now study the
level, the slope and the convexity if the yield curve, trying to understand what are the expected
macroeconomic variables innovations that affect them. The yield curve is therefore used to
analyze market risks that are generated by shocks hitting macroeconomic variables. In normal
conditions the yield curve has a positive slope.

When instead the slope becomes negative, the yield curve suggests that a recession is
expected. Standard monetary policy in fact requires the central to respond to deviations from
target of inflation and output. The central bank responds to recessions, typically associated with
deflation, by lowering rates. An inverted yield curve therefore implies recessionary expectations.
Caveat: the inversion of the yield curve has anticipated twelve of the last seven recsssions...