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The shape of sovereign yield curve in an emerging economy: Do macroeconomic or external factors matter?

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Abstract

We study the dynamic relation between sovereign yield curve and external shocks driven by global uncertainty and capital inflows. A Nelson–Siegel model is estimated to capture the three latent factors of the yield curve corresponding to level, slope and curvature. The state-space representation of the model is used to document the dynamic relation between the factors of the yield curve, the domestic macroeconomic variables (capacity utilization ratio, inflation, and monetary policy rate) and the external factors (global risk perception and capital flows). We find that although domestic macroeconomic variables have some impact on the future shape of the yield curve, the impact is becoming weaker after the 2008 global financial crisis. The results suggest that external factors emerge to have sizeable and significant impact on both macroeconomic variables and the latent factors. These results have important policy implications for policymakers especially for central bankers and debt managers when capital flows have been a major concern after the 2008 global financial crisis.

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Notes

  1. Please see Telatar et al. (2003) how political instability distorts the relationship between the term structure of interest rates and macroeconomic aggregates.

  2. The macroeconomic factors are selected in the spirit of Diebold et al. (2006) to represent the state of economy. There can be other factors representing the state of economy in an emerging economy, just like foreign exchange rates. This can be especially valid for Turkey since exchange rate pass-through to inflation has been prominent during the sample period. However, the literature on the yield curve models that incorporate foreign exchange variables is so slim. Important exceptions are those of Chen and Tsang (2013) and Stavrakeva and Tang (2016) who study the yield curve in predicting foreign exchange levels in advanced economies and the contemporaneous relation between yields and currency appreciation, respectively. Yet, there is not a consensus on extracting the information from foreign exchange rates. Stavrakeva and Tang (2016), for instance, decompose exchange rates into five terms including, uncovered interest rate parity, excess returns, expectations about future excess returns, change in expectations about future excess returns and changes in expectations over the long-run nominal exchange rate. This sort of conflict in a newly flourishing literature motivates us to ignore the possible impacts of movements in foreign exchange rates on yield curve. We are however confident that the information in foreign exchange rates is to some extent captured by the monetary policy rate (ir), given that central banks in emerging economies often consider foreign exchange movements for financial stability concerns and take action accordingly. So that the information loss arising from the absence of foreign exchange rate in the model is more or less compensated.

  3. The number of different maturities used in this paper is slightly less than the maturities used in many other papers (see e.g. Diebold et al. 2005; Diebold and Li 2006) which study the yield curve in advanced bond markets. This is because the long end of the Turkish yield curve is still around 10 years maturity and is shorter than many yield curves in advanced bond markets.

  4. We will also elaborate on this phenomenon when we discuss the VAR results in the upcoming section.

  5. The own-lag coefficient of L(t) rounds to 1.08 but stationarity is assured since the largest eigenvalue of the A matrix is smaller than 1.

  6. We estimate several other orderings to observe possible changes, but the main dynamic relations do not change.

  7. The phrase short-termism refers to investment behaviour of agents in the financial intermediation chain weighing near-term outcomes too heavily at the expense of longer-term opportunities and thus forgoing valuable investment projects and potential output (Davies et al. 2014). The phrase also contains the meaning of herding behaviour during turbulent times.

  8. To keep the average return on assets constant, investors have incentives to shift into riskier credit market segments which is a highly visited phenomenon after 2008 under the name of “search for yield”.

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Acknowledgements

We are grateful to Fritz Breuss (the Editor) and an anonymous referee for helpful comments. We also thank Ali Bircan for his assistance in computations. The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of the Central Bank of the Republic of Turkey. All errors and omissions are our own.

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    Huseyin Ozturk

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Ozturk, H. The shape of sovereign yield curve in an emerging economy: Do macroeconomic or external factors matter?. Empirica 47, 83–112 (2020). https://doi.org/10.1007/s10663-018-9405-y

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