Another look at yield spreads: the role of liquidity

Southern Economic Journal, April, 2008 by Dong Heon Kim

1. Introduction

The expectations hypothesis (hereafter EH) of the term structure of interest rates states that the long-term rate is determined by the expectation for the short-term rate plus a constant term premium. With rational expectations, one of the EH implications is that the coefficient in a regression of the change in expected future short-term interest rates on the current yield spread between long- and short-term rates is unity. Many empirical studies, such as Shiller, Campbell, and Schoenholtz (1983), Fama (1984), Mankiw and Miron (1986), Fama and Bliss (1987), Hardouvelis (1988), Mishkin (1988), Froot (1989), Simon (1989, 1990), Cook and Hahn (1990), Campbell and Shiller (1991), and Roberds, Runkle, and Whiteman (1996), among others, have shown mixed results, with more evidence against the EH than in its favor. (1) Even though Fama (1984), Hardouvelis (1988), Mishkin (1988), and Simon (1990) have found yield spreads do help predict future rates, the coefficient appears inconsistent with the EH. (2) Thornton (2006) argues that analysis should not be based on the slope coefficient of the test equation only, because even under the alternative hypothesis where the EH does not hold, one can have slopes that are numerically close to the theoretical ones.

Several studies have shown that even if the EH does hold, it would be hard to use it for forecasting due to interest rate smoothing by the Federal Reserve System (Fed). (3) On the other hand, a number of studies have focused on the possibility of a time-varying risk premium and concluded that a time-varying risk premium can help explain the failures of the EH. (4) From a study of time variation in expected excess bond returns, Cochrane and Piazzesi (2005) find that a single factor, which is a single tent-shaped linear combination of forward rates, predicts excess returns on one- to five-year maturity bonds and strengthens the evidence against the EH. Wachter (2006) shows that a consumption-based model in which external habit persistence from Campbell and Cochrane (1999) and the short-term interest rate that makes long bonds risky are the driving forces for time-varying risk premia on real bonds.

However, Evans and Lewis (1994) argue that a time-varying risk premium alone is not sufficient to explain the time-varying term premium observed in the Treasury bill. Dotsey and Otrok (1995) suggest that a deeper understanding of interest rate behavior will be produced by jointly taking into account the behavior of the monetary authority along with a more detailed understanding of what determines term premia. Diebold, Piazzesi, and Rudebusch (2005) state that from a macroeconomic prospective, the short-term interest rate is a policy instrument under the direct control of the central bank, which adjusts the rate to achieve its economic stabilization goals; from a finance prospective, the short rate is a fundamental building block for yields of other maturities, which are just risk-adjusted averages of the expected future short rate. They suggest that a joint macro-finance modeling strategy will provide the most comprehensive understanding of the term structure of interest rates.

Recently, Bansal and Coleman (1996) argued that some assets other than money play a special role in facilitating transactions, which affects the rate of return that they offer. In their model, securities that back checkable deposits provide a transactions service return in addition to their nominal return. Since short-term government bonds facilitate transactions by backing checkable deposits, this results in equilibrium with a lower nominal return for these bonds. Such a view implies that liquidity plays an important role in determining the returns of various securities. So, if liquidity is an important factor determining the returns of financial assets, liquidity may also be important for yield spreads and the term structure of interest rates. But how do investors consider liquidity in allocating their funds between securities of different terms? Since commercial banks are the principal investors and primary dealers in instruments such as federal funds, commercial paper (hereafter CP), and Eurodollar CDs, a study of liquidity demand by commercial banks may provide the key to answering this question. (5,6)

This paper attempts to answer the following question: Can the fact that liquidity plays an important role in explaining how banks determine their allocation of funds explain yield spreads and help provide an explanation for the failure of the EH?

If a bank might, at some point, be unable to turn its assets into ready cash, the bank faces a liquidity risk. Liquidity is a crucial fact of life for banks, and for this reason may have an implication for yield spreads and the term structure of interest rates. In addition, because banks' liquidity can vary as a result of Fed policy, financial market conditions, an individual bank's specific demand for reserves, and so on, banks' liquidity might play an important role in explaining time-varying term premia. Most previous studies, however, have not focused on banks as the main investors in financial markets and, thus, have not considered the role of banks' liquidity.