Market volatility, monetary policy and the term premium

(first published in January 2017, revised in June 2022)

In this paper, we use time-varying VAR models to study the effects of option-implied measures of equity and bond market volatilities on the government bond term premium and key macroeconomic variables. We show that the high correlation between the two volatilities requires that shocks to these variables be jointly identified. We find that a positive shock to the VIX reduces the term premium. We interpret this effect as the result of investors shifting their portfolios away from riskier assets. The positive shock to the VIX also has contractionary and disinflationary effects. By contrast, a positive shock to the MOVE, which reflects heightened uncertainty about future changes in interest rates, raises the term premium. Similar to a VIX shock, an increase in bond market volatility also has a contractionary effect, although the negative effects on output and inflation are smaller. Both VIX and MOVE shocks resemble negative demand shocks, albeit of different intensity, to which the central bank responds by easing monetary policy. Depending on the type of volatility impacting the economy, a contraction in output can be associated with either a flattening or steepening of the yield curve.

JEL classification: E43, E44, E52

Keywords: VIX, MOVE, time-varying VAR, market volatility, bonds, equities, term premium, monetary policy