Brent Ballard ECON 700 Project The Impact of Monetary Policy on High Grade Corporate Yield Spreads Fall 2009

2 2 Contents I.Introduction II.Method III.Data IV.Model V.Results VI.Conclusions

Introduction

4 4  Research Goals Explore the effect that changes in monetary policy have on the yield spread between high-grade corporate bonds and treasury securities Quantify that response by introducing a policy dummy into a model for the yield spread to measure the effect that it has on the response variable  U.S. Monetary Policy The U.S. Federal Reserve aims to promote maximum employment, stable prices, and moderate long-term interest rates by influencing monetary and credit conditions in the economy – Policy Objectives – Transmission Mechanisms – It is important that we understand how these policy transmission mechanisms operate, both to ensure that monetary policy achieves its intended result, and so that we might predict any unintended financial consequences of these policy actions  Yield Spread Risk Premium Idiosyncratic risk in the economy is manifested in the yield spread

Method

6 6  The Policy Dummy Public minutes of FOMC meetings between January, 1964 and December, 2003 Dummy = 0 – If a policy directive is issued instructing the committee to maintain the prevailing level of pressure on credit conditions, dummy = 0 is assigned for that month Dummy = 1 – If a directive is issued instructing the FOMC to either increase or decrease the level of pressure on credit conditions by any magnitude, and that directive is maintained following four consecutive meetings or more, dummy = 1 is assigned to each month during which that instruction persists – Similarly, if a directive is issued ordering the committee to either increase or decrease the prevailing degree of pressure on credit conditions significantly, dummy = 1 is assigned for that month  A Note Regarding FOMC Policy Directives Whether the Fed pursues its policy objectives by targeting a specific federal funds rate, or by targeting a certain level for the money supply, there is always some mention in the directive regarding the pressure to be exerted on credit conditions in the economy. Thus, the presence of a policy dummy is dependant on for how long and to what degree a change in the pressure applied to these credit conditions persits The dummy is consistent in the way that it distinguishes between different policy directions

Data

8 8 Data (1)  Dependent Variable Difference between the Moody’s Aaa-rated corporate bond index yield and the 10 – Year yield  Independent Variables U.S. Gross Domestic Product (GDP) Standard & Poor’s 500 Equity Index (S&P) Consumer Price Index (CPI) Producer Price Index (PPI) Spot Price of Oil (OIL)  Non-Stationary Variables A graph of our outcome measure reveals that the yield spread exhibits a consistent upward trend over the course of the sample period – The presence of this trend demands that tests are performed to determine whether the series is non-stationary (1)Data collected from the Federal Reserve Economic Database

9 9 Yield Spread  Non-Stationarity The following tests for unit roots are applied in order to determine whether the series is non- stationary –Augmented Dickey Fuller Test –Phillips-Perron Test –Correlogram Trend-Stationarity Bartlett’s formula for MA(q) 95% confidence bands Lag Autocorrelations of yield spread

10 Yield Spread Series - Trend Removed  Trend-Stationarity The modified series is stationary Correlogram confirms trend-stationarity Bartlett’s formula for MA(q) 95% confidence bands Lag Autocorrelations of yield spread

The Model

12 Model  Model Specification An ADL model is specified to predict the yield spread – Four consecutive single period lags of each variable are included in the model  The Model: Y t = α 0 + β 0 L 4 (Y t )+ β 1 S&P t + β 2 L 4 (S&P t ) + β 3 GDP t + β 4 L 4 (GDP t ) + β 5 CPI t + β 6 L 4 (CPI t ) + β 7 PPI t + β 8 L 4 (PPI t ) + β 9 OIL t + β 10 L 4 (OIL t ) + ε t (L 4 ) indicates four consecutive single period lags of the preceding variable

13 Independent Variables – Non-Stationarity  Non-Stationarity Non-stationary independent variables Stationary first differences Possibility of cointegration Stationary residuals Model run with first differenced dependant and independent variables predicts a similar result We are confident that the results are robust

Results

15 ADL Estimation Results *** Denotes significance at the 1% level ** Denotes significance at the 5% level * Denotes significance at the 10% level Dummy Lags Instantaneous: Y t = α 0 + β 0 L 4 (Y t )+ … + β n DUMMY t 1M Lag: Y t = α 0 + β 0 L 4 (Y t )+ … + β n DUMMY t-1 3M Lag: Y t = α 0 + β 0 L 4 (Y t )+ … + β n DUMMY t-3 6M Lag: Y t = α 0 + β 0 L 4 (Y t )+ … + β n DUMMY t-6 1Y Lag: Y t = α 0 + β 0 L 4 (Y t )+ … + β n DUMMY t-12

16 Results  Effect of the policy dummy The policy dummy is statistically significant (t=-3.43) and has improved the overall fit of our model. The instantaneous effect of the policy dummy is a 6 basis point decline in the yield spread, while one-month and three-month lags of the dummy decrease the spread by an additional 4 and 6 basis points respectively – Because the six-month and one-year lags of the policy dummy are insignificant, we can be confident that the measured effect of the dummy on the yield spread is not merely a coincidental result Since the spread of the Aaa-rated corporate bond index averaged roughly 86 basis points between 1964 and 2003, the effect of the policy dummy on the yield spread is equivalent to an immediate 7% decline relative to the average spread, and a 20% decline over the three-month period following the initial policy action  Residuals

Conclusions

18 Conclusions  Implications for market risk While the empirical results of our research indicate that changes in monetary policy reduce the yield spread, they do not necessarily suggest that policy interventions reduce the level of perceived risk in the economy – Rather, the results reveal that treasury yields respond more acutely to monetary policy action than those of Aaa corporates – When the model is regressed employing the 10-year yield and the Aaa index yield as unique dependant variables, we find that the policy dummy is positive and significant in both cases, but that it has a decidedly greater impact on the treasury yield (15 bps) relative to the index yield (9 bps)  Explanations Because investors in treasury securities are more attentive to the actions of the Fed, it may be that greater trading volume in the treasury market following a policy intervention results in a more rapid adjustment in the prices and yields of those assets An alternative explanation for our result is that treasury yields overreact to changes in policy relative to the Aaa index yield. Because high-grade corporate bonds are traded so infrequently, their tempered response to the policy dummy could indicate that the long-term outlook regarding market risk is not so severely altered as changes in treasury yields suggest

19 Conclusions  Final Thoughts While it could not be concluded from this research that open market operations reduce the level of perceived risk in the economy, one might reasonably propose that changes in short-term market outlook following a policy intervention are not always indicative of the long-term trend in risk perception In any case, further exploration of the mechanisms linking monetary policy to reactions in the financial markets is an intriguing topic for future research Aaa Index Yield Trend 10-Year Yield Trend

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