Why Do Term Structures in Different Currencies Comove?

Abstract

Yield curve fluctuations across different currencies are highly correlated. This paper investigates this phenomenon by exploring the channels through which macroeconomic shocks are transmitted across borders. Macroeconomic shocks affect current and expected future short-term rates as central banks react to changing economic environments. Investors may also respond to these shocks by altering their required compensation for risk. Macroeconomic shocks thus influence bond yields both through a “policy” channel as well as through a “risk compensation” channel. Using data from the U.S., the U.K., and Germany, we find that world inflation and U.S. yield level together explain over two-thirds of the co-variance of yields at all maturities. Further, these effects operate largely through the risk compensation channel for long-term bonds.

Keywords: Macro-finance term structure model, interest rates, cross-country comovement

JEL Classification: G12, G15, E43, C58