Yield Curve and Financial Uncertainty: Evidence Based on US Data

• Author: Efrem Castelnuovo
• DOI: http://doi.org/10.1111/1467-8462.12341
• Published date: 01 September 2019
• Date: 01 September 2019

The Australian Economic Review, vol. 52, no. 3, pp. 323–335 DOI: 10.1111/1467-8462.12341

Yield Curve and Financial Uncertainty: Evidence Based on

US Data

Efrem Castelnuovo*

Abstract

How do short‐and long‐term interest rates

respondtoajumpinfinancial uncertainty? We

address this question by conducting a local

projections analysis with US monthly data,

period: 1962–2018. The state‐of‐the‐art financial

uncertainty measure proposed by Ludvigson, Ma

and Ng (2019) is found to predict movements in

interest rates at different maturities. In particular,

an increase in financial uncertainty is found to

trigger a negative and significant response of

both short‐and long‐term interest rates. The

response of the short end of the yield curve (i.e.,

of short‐term interest rates) is found to be

stronger than that of the long end (i.e., of long‐

term ones). In other words, a financial un-

certainty shock causes a temporary steepening of

the yield curve. This result is consistent, among

other interpretations, with medium‐term expecta-

tions of a recovery in real activity after a

financial uncertainty shock.

1. Introduction

How does the yield curve respond to changes

in financial uncertainty? While many recent

studies have quantified the effects of different

types of uncertainty shocks on output, un-

employment and inflation, the impact of

jumps in uncertainty on short‐and (above

all) long‐term interest rates has been much

less scrutinised. This is somewhat surprising,

given the relevance of long‐term interest

rates for households’consumption decisions

and entrepreneurs’investment and labour

demand.

This paper contributes to filling this gap by

estimating the response of a battery of interest

rates of US Government bonds with different

maturities over the period 1962–2018. We use

local projections à la Jordà (2005) to produce

the impulse responses of such interest rates to a

jump in the state‐of‐the‐art financial uncertainty

measure recently proposed by Ludvigson, Ma

and Ng (2019). We find financial uncertainty to

negatively and significantly impact all the

elements of the term structure we consider.

Talking about maturities, we find a stronger

response of the short end of the term structure

(which relates to short‐term interest rates). The

peak response of the 3‐month interest rate is

found to be close to –0.4 percentage points,

while that of the 10‐year yield is estimated to be

about –0.2 percentage points to a jump in

uncertainty (the size of the jump being one

standard deviation). The positive slope of the

yield curve (the sign of the slope of the yield

curve being captured by the difference between

long‐term and short‐term rates) conditional on a

* University of Melbourne, Melbourne, Victoria 3010

Australia and University of Padova Centre for Applied

Macroeconomic Analysis, Padova 35123 Italy; email

<efrem.castelnuovo@unimelb.edu.au>. We thank Martin

Andreasen, Giovanni Caggiano, Julie Moschion, and

especially Giovanni Pellegrino for valuable comments.

Financial support by the Australian Research Council via

the Discovery Grant DP160102281 is gratefully acknowl-

edged.

© 2019 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research,

Faculty of Business and Economics

Published by John Wiley & Sons Australia, Ltd