Accounting for a Shift in Term Structure Behavior with No-Arbitrage and Macro-Finance Models

By Rudebusch, Glenn D.; Wu, Tao | Journal of Money, Credit & Banking, March-April 2007 | Go to article overview

Accounting for a Shift in Term Structure Behavior with No-Arbitrage and Macro-Finance Models


Rudebusch, Glenn D., Wu, Tao, Journal of Money, Credit & Banking


DURING THE PAST few decades, the U.S. economy has undergone an important transformation that has likely altered the nature of uncertainty and risk in the economy as well as investors' attitudes and pricing of that risk. A key aspect of this transformation is the precipitous decline in overall macroeconomic volatility: since the middle of the 1980s, the volatility of real GDP growth has been about 35% lower than earlier in the postwar period (as noted by Kim and Nelson 1999, McConnell and Perez-Quiros 2000). Several factors may underlie this "Great Moderation" in economic fluctuations. (1) For example, better economic policy in the later sample may have helped stabilize the economy; indeed, many have argued that the conduct of U.S. monetary policy improved dramatically during the mid-1980s, helping to usher in the current period of diminished output volatility as well as remarkably low and stable inflation. Alternatively, the recent quiescence in real activity and inflation may largely reflect good luck--that is, a temporary run of smaller economic shocks. Other potentially important factors include non-policy changes in the dynamics of the economy arising from, for example, improved inventory management or a greater share in aggregate output accounted for by the relatively stable service sector. Finally, the development of deeper and more integrated financial markets and the introduction of new financial instruments may also have played a role both in damping the magnitude of economic fluctuations and in mitigating their effects on investors. Given such dramatic shifts in the economic environment, a change in the behavior of the term structure of interest rates, and especially in the size and dynamics of risk premiums, would hardly be surprising.

This paper examines how the dynamics of the term structure and of interest rate risk may have changed over time. We use affine, no-arbitrage, asset pricing models of the type popular in the finance literature to investigate the recent shift in the behavior of the term structure; however, our investigation is also informed by the above literature on the recent transformation of the U.S. economy and by consideration of the macroeconomic underpinnings of the term structure factors in finance models. (2) The payoff from this joint analysis is bidirectional as well. The macro-finance perspective helps illuminate the nature of the shift in the behavior of the term structure, highlighting in particular the importance of a shift in investors' views regarding the risk associated with the inflation goals of the monetary authority. In addition, the shift in term structure behavior, as viewed using a no-arbitrage finance model, sheds light on the nature of recent macroeconomic changes. Specifically, if one assumes that the factors underlying recent changes in the macroeconomy have also left their imprint on the yield curve, the finance models suggest that more than just good luck was responsible for the recent macroeconomic transformation. Instead, a favorable change in economic dynamics, likely linked to a shift in the monetary policy environment, appears to have been an important element of the Great Moderation.

We begin our analysis in Section 1 with a simple empirical characterization of the recent shift in the term structure of U.S. interest rates. For this purpose, we use regressions of the change in a long-term interest rate on the lagged spread between long and short rates. Following Campbell and Shiller (1991), such regressions have been widely used to test the expectations hypothesis of the term structure, which assumes that the risk or term premiums embedded in long rates are constant. We find--as have many others--that these tests often reject the expectations hypothesis; however, of more interest for our purposes is the apparent significant shift in the estimated coefficients from these regressions. Indeed, since the mid-1980s, there is much less evidence against the expectations hypothesis than before, which suggests a shift in risk pricing and in the properties of risk premiums. …

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