Term premium dynamics and its determinants: the Mexican case

Summary

Focus

Term premia are an important component of long-term interest rates and have become more relevant with unconventional monetary policies. Since households' and businesses' savings and spending decisions can be influenced by such rates, the study of the dynamics of long-term interest rates and term premia is relevant for central banks and financial policymakers. Longer-term rates can be expressed as the sum of the average of the current short-term interest rate and its expectations for the long term. Central banks can influence the short-term interest rate through monetary policy actions and its expectations through their communication strategy.

Contribution

This paper estimates the two components of long-term interest rates in Mexico: the expected short-term interest rate and the term premium. The first is obtained using different methodologies. The second is computed as the difference between long-term and short-term interest rates. The Mexican term premium is represented by the average of the three estimations.

Findings

The results suggest that the main determinants of the evolution of the Mexican term premium are the US term premium as a global factor, real compensation and the compensation for FX risk as a proxy of the inflationary risk premium. We find that the Mexican term premium increased considerably during three episodes: (i) the Great Financial Crisis; (ii) the 2013 taper tantrum; and (iii) the 2016 US presidential election. In contrast, it decreased to historically low levels during the US quantitative easing programmes.

Abstract

We estimate the term premium implicit in 10-year Mexican government bonds from 2004 to 2019, and analyze the main determinants explaining its dynamics. To do so, we decompose the long-term interest rate into its two components: the expected shortterm interest rate and the term premium. The first component is obtained using different methodologies, two affine models and data on interest rate swaps. The second component is computed as the difference between long-term interest rates and such short-term rate. The Mexican term premium is represented by the average of the three estimations. We find that the Mexican term premium increased considerably during three episodes compared to the entire dynamics of said premium: i) the Global Financial Crisis of 2008; ii) the Taper Tantrum of 2013; and iii) the U.S. presidential election of 2016. In contrast, we find that the Mexican term premium decreased, to historically low levels, during the U.S. Quantitative Easing and Operation Twist programs. Additionally, in order to identify the main determinants that explain the behavior of this premium, we run a time varying parameters regression. In this analysis, we find that the main determinants that explain the dynamics of the premium are the compensation for FX risk (as a proxy of inflationary risk premium), the real compensation, and the U.S. term premium (as a global factor).

JEL classification: G12, E43, C12, C53.

Keywords: term premium, short-term interest rate expectation, affine model.