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Rate-Amplifying Demand and the Excess Sensitivity of Long-Term Rates

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Abstract

Long-term nominal interest rates are surprisingly sensitive to high-frequency (daily or monthly) movements in short-term rates. Since 2000, this high-frequency sensitivity has grown even stronger in U.S. data. By contrast, the association between low-frequency changes (at six- or twelve-month horizons) in long- and short-term rates, which was also strong before 2000, has weakened substantially. This puzzling post-2000 pattern arises because increases in short rates temporarily raise the term premium component of long-term yields, leading long rates to temporarily overreact to changes in short rates. The frequency-dependent excess sensitivity of long-term rates that we observe in recent years is best understood using a model in which (i) declines in short rates trigger “rate-amplifying” shifts in investor demand for long-term bonds and (ii) the arbitrage response to these demand shifts is both limited and slow. We study, both theoretically and empirically, how such rate-amplifying demand can be traced to mortgage refinancing activity, investors who extrapolate recent changes in short rates, and investors who “reach for yield” when short rates fall. We discuss the implications of our findings for the validity of event-study methodologies and the transmission of monetary policy.

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  • Samuel Hanson & David O. Lucca & Jonathan H. Wright, 2017. "Rate-Amplifying Demand and the Excess Sensitivity of Long-Term Rates," Staff Reports 810, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednsr:810
    Note: Revised April 2021. Previous titles: “The Excess Sensitivity of Long-Term Rates: A Tale of Two Frequencies" and before that, "Interest Rate Conundrums in the Twenty-First Century”
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    Cited by:

    1. Leombroni, Matteo & Vedolin, Andrea & Venter, Gyuri & Whelan, Paul, 2018. "Central Bank Communication and the Yield Curve," CEPR Discussion Papers 12970, C.E.P.R. Discussion Papers.

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    More about this item

    Keywords

    monetary policy transmission; conundrum; interest rates;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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