“Monetary policy makers want to control the long end of the yield curve,” said Paul Whelan at a webinar on January 16, 2014 sponsored by the Global Association of Risk Professionals. Whelan co-authored an article that won the 2013 GARP Award for best paper in financial risk management.
“Monetary Policy and Treasury Risk Premia”, by Andrea Buraschi, Andrea Carnelli, and Paul Whelan, provides a quantitative analysis of the effect of monetary policy shocks on future bond returns. Buraschi is at the University of Chicago Booth School of Business and Imperial College London; Carnelli is at Imperial College London; and Paul Whelan is at Imperial College London and the European Central Bank.
Whelan noted that motivation for this project came from a few related points:
(1) Monetary policy makers would like to control the long end of the yield curve since this is what really determines consumers’ decisions to build a house, buy a car, etc. Unfortunately policy makers only have direct control over the very shortest rates.
(2) The actual policy effect at the long end is indirect, in the sense that it is an outcome of the markets’ physical expectation of future short rates (P measure) and possibly a risk neutral one (Q measure)
(3) Most studies have focused on “high-frequency” reactions of short-term versus long-term rates to policy announcements.
Part of the reason for this, he noted, is because traditional rational expectations models leave no room for policy to affect long-run consumption and thus risk compensation. What Whelan and co-authors found is that expectations about the path of monetary policy are in fact, priced, and the risk prices associated with these shocks are time-varying.
The area of long-term effects of monetary policy had not been explored before, and this was the noteworthy contribution recognized by the GARP award. Portfolio managers might in future want to incorporate monetary policy in algorithms for fixed income tactical allocation, Whelan said, if a link could indeed be found. ª
Whelan then walked the audience through the mechanics of their determination; click here to go to Part 2. ª
The webinar presentation slides can be found at: http://event.on24.com/r.htm?e=711834&s=1&k=63A3B83C6DB9770EAD9D824BCBB1C272
The research paper it’s based on can be found at: http://www.efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2013-Reading/papers/EFMA2013_0590_fullpaper.pdf