NEWS Release - Dissecting the yield curve: a central bank perspective - Welcome remarks by Benoît Cœuré, Member of the Executive Board of the ECB, at the annual meeting of the ECB’s Bond Market Contact Group, Frankfurt am Main, 16 May 2017
Ladies and gentlemen, Let me welcome you again and thank you for coming to Frankfurt to share your views and insights with us. [1] As you might know, just a few weeks ago I gave a speech[2] in Paris that addressed possible spill-overs from the repo market to the government bond market – a topic that you also discussed today and where I believe further work is needed to develop our understanding and guide policy deliberations.
In my remarks this evening I would like to address a different topic, but one that is no less important: how central banks interpret yield curve movements, and how this process might influence our monetary policy considerations.
Policy actions and the yield curve
Let me start by clarifying what I mean by “yield curve”.
This is not a trivial discussion in a currency union with 19 different yield curves. Among these, we generally consider that two curves in particular provide us with insight and inform our policy decisions: the overnight index swaps (OIS) curve and the Bund curve, as these have become widely accepted proxies for risk-free yields in the euro area.[3] As such, they serve as the bedrock for pricing virtually all credit products and related derivatives.
These curves are vital for the transmission of monetary policy, as they have a significant influence on broad asset valuations and the pricing of bank loans and, ultimately, they affect the investment and saving decisions of households and firms.
This means that we need to understand – as much as you do – what drives changes in these curves, so we can draw correct inferences regarding the appropriateness of our monetary policy stance. This has become all the more important in an environment where central banks no longer only control very short-term policy rates but also influence long-term yields through asset purchases.
In other words, we need to make a quantitative distinction as to what part of a given change in the yield curve is likely due to policy itself – our actions and often also our words – and what part is due to other factors, such as spillovers from abroad or improved growth expectations.
A natural starting point for such an analysis is the use of dynamic term structure models that divide yields into two key components – an expectations component and a term premium.
The expectations component reflects the average of current and future expected short-term rates over the maturity of the bond. If the pure expectations hypothesis of the term structure were to hold, this would be all that mattered in terms of explaining movements in long-term rates.
But broad empirical evidence suggests that the pure expectations hypothesis fails to hold true in practice, and that there is indeed a time-varying premium that investors require in order to hold a long-term bond instead of simply rolling over a series of short-term bonds.[4]
Monetary policy – and there we are increasingly certain – cannot only influence the expectations component, but also the term premium.
Three examples demonstrate this more clearly.
First, by changing our key policy rates, we can directly impact the short end of the curve – the footing of the expectations component. In normal times, medium to long-term rates would adjust to the extent that market participants would see a change in policy rates as the beginning of an incremental series of changes.
But with short-term policy rates approaching levels closer to zero during the early phases of the most recent easing cycle, this channel had become less effective. Markets – in the belief that rates could not enter negative territory – stopped short of pricing in the degree of accommodation they would normally have expected in the face of downside risks to our price stability mandate.
Our decision in June 2014 to introduce negative deposit facility rates restored our ability to steer market expectations and thereby also medium to long-term rates. Indeed, by signalling to the market that policy rates could go below zero, we ultimately succeeded in shifting downwards the entire distribution of future expected short-term rates, thereby providing important additional accommodation.[5]
Second, and related, by communicating about where we see the economy heading, and by clarifying our ‘reaction function’ – that is, by providing forward guidance – we can directly influence expectations regarding future short-term rates.
Forward guidance has served us well and has contributed to keeping the short to medium end of the yield curve well anchored at times when external shocks were threatening to unduly tighten financial conditions.
I will come back to this in a minute. But to the extent that forward guidance reduced uncertainty about the future path of interest rates, it has not only affected the expectations component but also the term premium.
Yet, the main channel through which we – and other major central banks – have recently exerted measurable downward pressure on the term premium, and this is my third example, is through asset purchases. We now have a growing body of evidence that suggests that central banks can lower long-term rates by removing duration risk from the market.
For example, according to ECB estimates, our monetary policy measures have contributed to reducing euro-area long-term risk-free rates by around 80 basis points since June 2014.[6] Asset purchases have contributed significantly to this drop and have therefore been an indispensable tool to create the financial conditions necessary for inflation to move back towards levels consistent with price stability.
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