Bringing to light the unobservable term premium of Euro Area government bonds
The financial crisis and, more recently, the coronavirus pandemic, have posed new challenges for the European Central Bank (ECB). To stabilise financial markets and stimulate economic growth, the ECB adopted unconventional monetary policy measures, such as negative interest rates and quantitative easing. In this context, a clear understanding of the forces underlying the movements in interest rates is highly relevant. Focusing on one of the two main components of interest rates, the EUTERPE project, with support from the Marie Skłodowska-Curie Actions programme, implemented an innovative system producing timely and reliable estimates of the ‘term premium’ for government bonds of the euro area (EA).
Separating the two fundamental components of interest rates
The yield curve of government bonds is used to predict changes in economic growth and is vital for the transmission of monetary policy. However, proper interpretation of yield curve information requires separating the two fundamental components of interest rates: the expectations component and the term premium. Project coordinator of EUTERPE, Andrea Berardi, explains: “The expectation component in yields reflects the average of current and future expected short-term rates over the maturity of the yield, while the term premium component represents the additional compensation investors demand to hold a longer-term bond relative to a series of shorter-term bonds, thus reflecting market participants’ uncertainty with respect to future interest rates. The distinction between the two components is crucial for central bankers.” The EUTERPE project aimed to disentangle the term premia from expectations of future interest rates and developed a new analytical tool with various applications for European policymakers and the financial industry. Specifically, the project results showed that long-term yields can be split into several components, each with a specific economic content. The practical analytical tool developed will help to derive estimates for all these unobservable variables from market data. “We might say that ‘it makes visible the unobservable’ in the term structure of interest rates,” says Monica Billio, supervisor of the project. In this regard, the application of the EUTERPE methodology may represent a very useful tool for central bankers making monetary policy decisions.
A unique European database
The project also developed a system of indicators calculating the exposure of EA government bonds to diverse risks. “Looking in particular at the European dimension, these techniques may provide a contribution, for example, to the new legislation for a Pan-European Personal Pension Product or the development of a comprehensive model for European asset allocation in the context of the European Commission’s new Action Plan for a Capital Markets Union,” notes Berardi. To disseminate the findings as broadly as possible, the project’s website content can be divided into three sections: a scientific section including technical notes, working papers and publications; a data section including downloadable estimates of the term premium and interest rate expectations for EA countries; and a popular science section. “All these sections will be updated monthly to provide a unique database, which can be useful not only to policymakers, but also to long-term investors and researchers, and with potential to become a reference point at European level,” adds Berardi.
Keywords
EUTERPE, term premium, interest rates, government bonds, yield curve, European Central Bank, Euro Area, long-term investors
