Treasuries variance decomposition and the impact of monetary policy

• Published date: 01 October 2019
• Author: Zivile Zekaite,Alexandros Kontonikas,Charles Nolan,Michael Lamla
• DOI: http://doi.org/10.1002/ijfe.1744
• Date: 01 October 2019

RESEARCH ARTICLE

Treasuries variance decomposition and the impact of monetary

policy

Alexandros Kontonikas

1

| Charles Nolan

2

| Zivile Zekaite

3

| Michael Lamla

1

1

Essex Business School, Finance Subject

Group, University of Essex, Colchester,

CO4 3SQ, UK

2

Adam Smith Business School, Economics

Subject Area, University of Glasgow,

Glasgow, G12 8QQ, UK

3

Monetary Policy Division, Central Bank of

Ireland, North Wall Quay, Dublin, D01

F7X3, Ireland

Correspondence

Prof. Alexandros Kontonikas, Essex

Business School, Finance Subject Group,

University of Essex, Colchester CO4 3SQ,

UK.

Email: a.kontonikas@essex.ac.uk

Abstract

This paper investigates the effect of monetary policy shifts on Treasuries over the

last three decades. We decompose unexpected excess returns on 2-, 5-, and 10-year

Treasuries in three components related to revisions in expectations (news) about

future excess returns, inflation, and real interest rates. We evaluate the impact of

conventional and unconventional monetary policy shocks on returns and their com-

ponents. Our results indicate that expansionary monetary policy shocks are associ-

ated with declining inflation expectations and higher Treasuries' returns.

KEYWORDS

bond market variance decomposition, financial crisis, monetary policy

JEL CLASSIFICATION

G12; G01; E44; E52

1|INTRODUCTION

The greatest part of the three-decade long bull-run in Trea-

suries took place within an environment of low and stable

inflation and sustained economic growth. Starting from the

mid-1980s, the macroeconomic tranquillity that defined the

Great Moderation era was accompanied by—some argue

delivered by—an apparently simple and predictable rule

underlying the conduct of monetary policy, based upon

targeting of the Federal funds rate (FFR). That era of stabil-

ity and predictability came to an abrupt end with the global

financial crisis of 2007–2009. As the zero lower bound on

interest rates constrained policymakers in the United States

and elsewhere, conventional monetary policy was unable to

boost economic activity. The Federal Reserve (Fed) adopted

nonconventional policy tools, including liquidity facilities

and outright purchases of Treasury bonds and other assets

from the private sector, to improve financial market condi-

tions and reduce longer term interest rates. After almost

6 years of unprecedented expansion in the Fed's balance

sheet, the end of quantitative easing (QE) was announced in

October 2014.

This study conducts an empirical investigation of the role

of monetary policy for Treasuries over the last three decades

using the framework of Campbell and Ammer (1993) (here-

after C/A). We use identities linking unexpected excess bond

returns to revisions in expectations (news) about future

excess returns, inflation, and real interest rates. To identify

the sources of the bond market's response to monetary policy

shocks, we modify Bernanke and Kuttner's (2005) extension

of C/A's framework so that it is applicable to bond market

returns.

1

At the first stage of our analysis, we decompose

unexpected excess returns on 2-, 5-, and 10-year Treasury

bonds to news about future excess returns, inflation, and real

interest rates. At the second stage, we evaluate the impact of

conventional and unconventional monetary policy shifts on

Treasury bond returns and their components. We use an

FFR-based measure to capture conventional policy shocks,

This work is based on a chapter of Dr. Zivile Zekaite's PhD thesis. The

views presented in this paper are those of the authors alone and do not

represent the official views of the Central Bank of Ireland or the European

System of Central Banks.

DOI: 10.1002/ijfe.1744

wileyonlinelibrary.com/journal/ijfe

Int J FinEcon. 2019;24:1506–1519.

1506

© 2019 John Wiley & Sons, Ltd.