Working Paper: NBER ID: w3153
Authors: John Y. Campbell; Robert J. Shiller
Abstract: The expectations theory of the term structure implies that the spread between a longer-term interest rate and a shorter-term interest rate forecasts two subsequent interest rate changes: the change in yield of the longer-term bond over the life of the shorter-term bond, and a weighted average of the changes in shorter-term rates over the life of the longer-term bond. For postwar U.S. data from Mcculloch [1987] and just about any combination of maturities between one month and ten years we find that the former relation is not borne out by the data, the latter roughly is. When the yield spread is high the yield on the longer-term bond tends to fall, contrary to the expectations theory; at the same time, the shorter-term interest rate tends to rise, just as the expectations theory requires. We discuss several possible interpretations of these findings. We argue that they are consistent with a model in which the spread is a multiple of the value implied by the expectations theory. This model could be generated by time-varying risk premia which are correlated with expected increases in short-term interest rates, or by a failure of rational expectations in our sample period.
Keywords: yield spreads; interest rates; expectations theory; term structure
JEL Codes: E43; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| yield spread (E43) | future changes in longer-term interest rate (E43) |
| yield spread (E43) | future changes in shorter-term interest rate (E43) |
| high yield spread (G12) | longer-term bond yield falls (E43) |
| high yield spread (G12) | shorter-term interest rate rises (E43) |
| yield spread (E43) | time-varying risk premia correlated with expected increases in short-term interest rates (E43) |
| yield spread (E43) | failure of rational expectations (D84) |