Revisiting the Financial Crisis: The Effect of Credit Shocks on Bond Yields Ram Yamarthy∗ New York University Mark J. Bertus Prize Winner
From the ﬁnancial crisis, it was apparent that traditional indicators such as real activity and inﬂation were insufﬁcient to explain spikes in bond yields. I discover the effect of credit indicators on bond yields by estimating a Gaussian six-factor afﬁne model of term structure. One of these factors is a credit variable that I construct using a principal component analysis of notable indicators. Using impulse response functions, I ﬁnd that positive credit movements raise interest rates at all maturities. Furthermore, shocks to credit have a greater immediate impact compared to those of real activity which are milder and more persistent.
I examine the impact of credit shocks on bond yields by estimating a Gaussian afﬁne term structure model, using Ang and Piazzesi (2003). My contribution to the model is a credit factor that I construct using a principal component analysis of notable credit variables. After determining parameters for our model through a numerical optimization of a likelihood function, our model supports yield data for the past twenty years. To understand the impact of the credit factor, I implement impulse response functions on bond yields. I ﬁnd that positive shocks to credit raise bond yields at all maturities of the yield curve. Because our credit variable is constructed such that positive shocks imply a looser credit environment, it is expected that positive impulses lower interest rates. In this way, our results contradict our expectations. Further, we ﬁnd that credit shocks have an immediate impact on the yield curve while real activity has a milder and more persistent effect. We have some possible explanations for these ﬁndings which includes our particular construction of the credit variable and the validity of our large parametric maximum likelihood estimation. I am greatly thankful for the kind advice and mentoring given by Thomas Sargent. By working with him I have been able to gain a greater understanding of this topic and the ﬁeld of economics in general. I would also like to specially thank David Backus, who has also been of extraordinary help in developing my ideas and guiding me towards graduate studies. I also thank Francisco Barillas, Espen Henriksen, and Boyan Jovanovic for helpful discussions. Finally, I would like to thank my parents and family for providing me the love and support to pursue an education at a top academic institution and further graduate studies. ∗
In the aftermath of the most recent ﬁnancial crisis, central banks were questioned in their approach to evaluating economic conditions. Beyond the traditional dual mandate of real growth and inﬂation, policymakers and lawmakers have called for a better management of asset prices and more speciﬁcally credit markets. In the United States, for example, there was a noticeable divergence between traditional economic indicators and measures of credit. Credit markets, measured through total consumer credit, experienced robust nominal growth rates, posting above 15% yearly growth in the mid 1990’s and early 2000’s. In Figures 1 and 2, we see that nominal growth rates of consumer and business credit have achieved large, absolute levels of ﬂuctuation, in comparison to those of real output and inﬂation. Similarly, if we examine key private lending rates, including those of commercial paper and corporate bonds over the last two decades, ﬂuctuations in key borrowing rates offset general stability in real economic activity and inﬂation. From this episode, is it fair to suggest that central banks should further utilize credit indicators in monetary policy? We will look to scratch the surface of this issue through the use of the yield curve. Fundamentally, yield curves provide a large amount of information to economic agents. In particular, yields allow...
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