A new paper proposes a measure for monetary policy surprises that arise from asset purchases and forward guidance. The idea is to estimate the change in the first principal component of government bond yields at different maturities to the extent that it is independent of changes in the policy reference rate and on days of significant policy statements. Such identified non-conventional policy shocks have had a persistent impact on yield curves and exchange rates since 2000. Their monitoring is important for so-called “long-long” risk parity trades.

Pericoli, Marcello and Giovanni Veronese (2017), “Monetary policy surprises over time”, Banca d’Italia, Temi di Discussione, Number 1102 – February 2017

The post ties in with SRSV’s lecture on macro trends, particularly the importance of fitting data into plausible theoretical models.

The below are excerpts from the paper. Emphasis and cursive text have been added.

How to measure monetary policy surprises

“Central banks have resorted to unconventional policies, including forward rate guidance, large-scale purchases of private and public securities and the broadening of the pool of assets eligible as collateral. This increased dimensionality of monetary policy operations complicates the task of finding a concise measure of the stance of monetary policy, and even more in defining private sector expectations over it.”

“We use a definition of monetary policy surprises that singles out movements in the long end of the yield curve, rather than those that change nearby futures on the central bank reference rates…a measure of monetary policy surprise can be recovered by examining the ‘joint’ movement in government bond yields around announcements. Looking at the shifts along the entire term structure, rather than at very short end, allows to detect also movements in long rates induced by announcements on forward guidance as well as on asset purchases.”

“Since our study spans both conventional and unconventional monetary policy periods, we…focus only on a particular component of the monetary policy surprise, the one stemming from the communication of policy beyond immediate target changes….to capture movements driven only by surprises regarding the ‘future-path’ of monetary policy, while excluding the news regarding the nearby ‘target’ for reference rates…We consider an…approach where we orthogonalize the first principal component factor [of the yield curve] from unexpected jumps at the short end of the curve.”

Principal components analysis reduces a large set of data series to a small set of uncorrelated principal components, trying to explain a maximum amount of variation with the reduced set. The first principal component is the linear combination of the original series that explains most of their variation.

Monetary policy days are selected as those with scheduled and unscheduled central bank board meetings as well as those with important central bank announcements…For the ECB we follow a narrative approach and we identify not only the days of the meetings of the GC but also consider relevant speeches of the ECB President, such as the pronouncement in July 2012…the ‘whatever it takes …’ speech…For the US, we use the regular meetings of the FOMC, semi-annual Congress testimonies by the Fed Chairman, relevant hearings of the Fed Chairman before the Congress Joint Economic Committee, and yearly speeches taken at the Jackson Hole conference.”

The impact of Fed and ECB surprises since 2000

“For each short term futures and bond yield, we run two regressions: the first on the futures contract for the [policy] reference rate and the second on the reference rate and our path factor….The effect of the path-factor is greater at the long-end of the yield curve and the effects remain quite persistent at the five-year horizon.”

“To ensure that surprises have ‘comparable’ nature across different periods we…focus on the response to path-factor shocks. Indeed…even before the global financial crisis…news stemming from the communication component of monetary policy had a more substantial and longer-lasting impact on the term structure than news stemming from decisions on policy interest rates.”

“Since the analysis spans pre-crisis years as well as the most recent period of unconventional monetary policies by the European Central Bank (ECB) and the US Federal Reserve (Fed) we do not attempt to estimate these reactions over a common sample, but rather split it into more homogenous periods.”

“We define a pre-crisis period from January 2000 until November 2008, the official start of the first Quantitative Easing program in the US. The second period, which we label crisis, runs from November 2008 to December 2012, a few months before the first ‘tapering’ announcement by the US Fed. The last period, which we label post-crisis, runs from January 2013 to September 2016, the end of our sample.

  • We find that during the ‘pre-crisis’ period path-surprises, both in the US and the euro area, propagate through the entire domestic term structure of interest rates with a hump-shaped pattern [meaning that the impact on 5-year yields is stronger than on either 2-year of 10-year yields]. For the euro area the shifts of the yield curve are also very similar across countries…A contractionary path-surprise [higher yields] by the Fed leads to a US dollar appreciation…A similar finding holds for the euro area.
  • In the ‘crisis-period’ the impact of US monetary policy path surprises along the term structure is no longer hump-shaped but it is increasing in tenor. This reflects largely the effect of movements in bond term premia, consistent with the functioning of a duration channel of monetary policy… In this period characterized by the sovereign debt crisis ECB surprises are now akin to a shock in the spread between sovereign yields of core and more vulnerable euro area economies. Unsurprisingly, ECB [easing] surprises lead to a reduction in sovereign spreads.
  • In the final ‘post-crisis’ period the transmission of monetary surprises to other asset prices becomes more in line with the ‘pre-crisis’ period. In particular, in the US the yield curve response morphs back to its conventional hump-shape pattern, although the term-premium component still accounts for a sizable fraction of the shifts.”
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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.