Channels of US monetary policy spillovers to international bond markets

Summary

Focus

Monetary policy spillovers from advanced economies into international asset markets have received renewed attention in the post-crisis period. This paper estimates the impact of US monetary policy shocks into international bond yields in a broad sample of developed and emerging market economies, and provides evidence with a view to uncovering the underlying transmission mechanisms involved.

Contribution

We identify US monetary policy shocks through short-term interest movements around FOMC meetings. To trace the underlying spillover mechanisms into international long-term bond yields, we apply an affine term-structure decomposition to separate the effects into movements in expected short-term rates (the risk-neutral component) and term premia. We also provide evidence on exchange rate fluctuations and fixed-income fund flows to help identify the transmission channels.

Findings

US monetary policy shocks are large, especially in the post-crisis period, where a 100 bp US shock after a FOMC meeting has increased international long-term yields by about 50 bp. This is economically important, and at least as large as the impact of domestic monetary policy actions. Moreover, spillovers work through different mechanisms. They are concentrated in risk-neutral rates (expectations of future policy rates) for developed countries, but predominantly on term premia in emerging markets. In interpreting these findings, we provide evidence consistent with an exchange rate channel, according to which foreign central banks face a trade-off between narrowing policy rate differentials, and experiencing currency movements. Developed countries adjust in a manner consistent with freely floating regimes, responding partially with risk-neutral rates (expectations of future policy rates), and partially through currency adjustments. By contrast, emerging market economies display patterns consistent with FX interventions, which cushion the response of exchange rates but reinforce capital flows and their effects in bond yields through movements in term premia. Our results suggest that the endogenous effects of currency interventions on long-term yields should be added into the standard cost-benefit analysis of such policies.

Abstract

We document significant US monetary policy (MP) spillovers to international bond markets. Our methodology identifies US MP shocks as the change in short-term treasury yields within a narrow window around FOMC meetings, and traces their effects on international bond yields using panel regressions. We emphasize three main results. First, US MP spillovers to long-term yields have increased substantially after the global financial crisis. Second, spillovers are large compared to the effects of other events, and at least as large as the effects of domestic MP after 2008. Third, spillovers work through different channels, concentrated in risk neutral rates (expectations of future MP rates) for developed countries, but predominantly on term premia in emerging markets. In interpreting these findings, we provide evidence consistent with an exchange rate channel, according to which foreign central banks face a tradeoff between narrowing MP rate differentials, or experiencing currency movements against the US dollar. Developed countries adjust in a manner consistent with freely floating regimes, responding partially with risk neutral rates, and partially through currency adjustments. Emerging countries display patterns consistent with FX interventions, which cushion the response of exchange rates but reinforce capital flows and their effects in bond yields through movements in term premia. Our results suggest that the endogenous effects of FXI on long-term yields should be added into the standard cost-benefit analysis of such policies.

JEL classification: E43, G12, G15

Keywords: monetary policy spillovers, risk neutral rates, term premia