Equilibrium models suggest that as long as the policy rate is firmly near zero, the term premium on longer-dated yields is compressed by a reduced sensitivity of rates to economic change. However, when policy rates are on the move again this sensitivity recovers, while proximity of the zero lower bound implies high economic risks and a surcharge on the term premia. Hence, term premium uncertainty would be highest at the time of “lift-off”, when policy rates are expected to move upward from near zero.

Nakata, Taisuke, and Hiroatsu Tanaka (2016). “Equilibrium Yield Curves and the Interest Rate Lower Bound,” Finance and Economics Discussion Series 2016-085. Washington: Board of Governors of the Federal Reserve System.

The post ties in with the subject of setback risks, a summary of which can be found here.

The below are excerpts from the paper. Headings and some other cursive text has been added for context and convenience of reading.

A general equilibrium model

“We study how the effective lower bound (ELB) constraint jointly affects the macroeconomy, the term structure of interest rates, and monetary policy in a structural general equilibrium model…The stylized model is a variation of a plain-vanilla New Keynesian model…In equilibrium, the goods market, labor market, and asset market must clear at all dates and states…The central bank sets the nominal one-period interest rate, following a Taylor rule…Explicit micro-foundations set our model apart from the existing term structure models with the ELB| which are mostly statistical models with limited economic structure.”

“The ELB constraint affects yield dynamics for all maturities. Not surprisingly, shorter maturity yields are more affected by the presence of the ELB than longer-maturity yields. Notice that, even when a longer-maturity yield is not constrained at the ELB, it can be influenced by the ELB constraint if the shorter-maturity yield is constrained.”

How the zero lower bound affects term premia

“The ELB constraint generates state-dependency in term premiums [i.e. the premium depends on the state of the economy] through two key factors…macroeconomic uncertainty and the sensitivity of interest rates to macroeconomic fluctuations.

  • On the one hand, macroeconomic uncertainty is higher when the policy rate is constrained by the effective lower bound than when it is not, as the ELB constraint prevents the central bank from counteracting the effects of exogenous shocks to demand on consumption and inflation. This increased macroeconomic uncertainty at and near the ELB constraint is a force that pushes up the absolute size of term premiums.
  • On the other hand, the sensitivity of interest rates to macroeconomic fluctuations is smaller when the policy rate is at or near the ELB than when it is not, as the central bank faces restrictions in adjusting its policy rate in the near term under such a circumstance. This reduced sensitivity of interest rates to macroeconomic fluctuations at and near the ELB constraint is a force that compresses the absolute size of term premiums.”

“Which of these two effects dominates depends on the state of the economy and yield maturity.

  • If the policy rate is expected to be at the ELB for a long period of time, the…compression effect typically dominates the…amplification effect, and the size of term premium is lower than when the policy rate is comfortably above the ELB…When…the policy rate is expected to be at the ELB for a short period of time, the…[amplification] effect often dominates…and the size of term premiums is higher than when the policy rate is comfortably above the ELB…
  • The compressing effects of the ELB on term premiums induced by the reduced sensitivity of interest rates is stronger for shorter-maturity yields that are more strongly affected by the presence of the ELB than longer-maturity yields.”

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“This time-variation in term premiums implies that term premium uncertainty- conditional volatility of term premiums – is particularly high when the policy rate is currently at the effective lower bound but is expected to be positive in the near future, or when the policy rate is currently positive but is near the ELB. That is, term premium uncertainty is particularly high around the time of liftoff.”

The effect of forward guidance

“We use our quantitative model to study the effects on the macroeconomy and the term structure of interest rates of the central bank’s announcement to keep the policy rate at the effective lower bound for longer than previously expected.”

“We find that this forward guidance not only reduces the expected short-rate path, but also the absolute size of term premiums. In our benchmark quantitative model in which term premiums are on average negative at the ELB, this…means that the forward guidance increases term premiums, partially offsetting the declines in the expected short rate path…That is, if bonds are a hedge against economic downturns and term premiums are negative at the time of announcement, then the announcement increases term premiums. Otherwise, it decreases term premiums.”

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Ralph Sueppel is founder and director of SRSV, a project dedicated to socially responsible macro trading strategies. He has worked in economics and finance for over 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.