Wednesday, May 20, 2015

Bond Yields, Macro Fundamentals, and Policy

Greetings my friends from Eurovision in Vienna. Yes, OK, that's not exactly the real reason I'm here, but still...

As I said in an earlier post that stressed DNS/AFNS yield-curve modeling with the zero lower bound imposed, "although Nelson-Siegel is almost thirty years old, and DNS/AFNS is almost a teenager, interesting and useful new variations keep coming." Another intriguing DNS/AFNS literature strand concerns the interaction of bond yields and macro fundamentals. That's hardly a new area, but recent work has some interesting twists.

Mesters, Schwaab and Koopman (2015) (MSK) focus on the effects of central bank policy on bond yields. There's lots of interesting new tech (stochastic volatility in measurement errors, interactions with non-Gaussian variables, a novel importance sampler for likelihood evaluation, ...). But most interestingly, MSK explore not only conventional policy tools like the overnight lending rate, but also direct measures of bond purchases.

MSK build on Diebold, Rudebusch and Aruoba (2006) (DRA), but the DRA emphasis is different. DRA were interested in whether and how the yield curve is linked to "standard" macro fundamentals. So DRA emphasized inflation, with an eye toward the yield curve level, and real activity, with an eye toward the yield curve slope. DRA also included an overnight lending rate, but certainly no measures of bond purchases.

Lots of interesting MSK-style work remains to be done. For example, someone needs to do an MSK-style analysis in a shadow-rate model that respects the zero lower bound and imposes no-arb. Also, someone needs to explore both causal directions more thoroughly. (Of course central bank bond purchases might influence the yield curve, but so too does the yield curve influence central bank bond purchases.)