Measuring Term Premia for the Euro Area - Updated Version

The dynamics of nominal government bond yields at different maturities plays a central role in shaping the response of the real economy to monetary and fiscal policy interventions.
Number: 6
Year: 2023
Author(s): Carlo A. Favero, Ruben Fernandez-Fuertes, Dev Srivastava

The dynamics of nominal government bond yields at different maturities play a central role in shaping the response of the real economy to monetary and fiscal policy interventions. Yields can be decomposed into two unobservable components: the sequence of expected one-period rates and the term-premia.

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The dynamics of nominal government bond yields at different maturities play a central role in shaping the response of the real economy to monetary and fiscal policy interventions. 

Yields can be decomposed into two unobservable components: the sequence of expected one-period rates and the term-premia (Campbell and Shiller, 1991Duffee, 2002). 

The first component reflects the future expected path of monetary policy rates, while the second reflects both macro fundamentals, including the prospects for growth, inflation and government debt dynamics, and the investors’ attitude toward risk. Policymakers are fully aware that the market-based financing conditions that matters for the control of the business cycle and inflation depend on both components of yields. 

Fluctuations in term premia are considered as important as the market perception of the future path of interest rates (Schnabel, 2023), and they are also used to evaluate the macroeconomic implications of monetary policy (Schnabel, 2022).

Term structure models are helpful in that they allow the identification of the two components by forecasting the expected path of interest rates and by imposing consistency with no-arbitrage restrictions for the derived term premia at different maturities.

The data tell us that yields are drifting, but excess returns are cyclical. In standard Affine Macro Term Structure (AMTS) models a few factors, modelled by a Vector Autoregressive Process, are the common drivers of the dynamics of both the expected path of future one-period rates and the term premia (Adrian et al., 2013; Wright, 2011).

As yields drift, factors exhibit a high level of persistence. When these factors are modeled using a VAR (Vector Autoregression), the forecast of future one-period rates gradually converges to the mean of the sample used for estimation. Standard AMTS models tend to generate term premia that are a-cyclical and parallel to the secular trend in yields.

These features of the term-premia are a by-product of the specification strategy for the dynamics of yields and excess-returns that adopts a common autoregressive factor structure for them (Bauer et al., 2014).

This website allows to compare risk premia derived for the US and the euro area from different approaches:

1. A standard AMTS model (ACM), by Adrian et al. (2013)

2. A new AMTS model in which yields drift, sharing a common stochastic trend driven by the drift in short-term (monetary policy) rates and excess returns are

stationary as the compensation for risk depends on the cycle in yields (FF) by Favero and Fernandez-Fuertes (2023).

3. A model-free approach in which the term premia are derived as the difference from observed yields and measure of the future path of expected short-term rates risk (FOMC forecast for the US and ECB survey of professional forecasters in the case of the euro area).

 

 

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