The Excess Sensitivity of Long-Term Rates: A Tale of Two Frequencies

Abstract

Long-term nominal interest rates are known to be highly sensitive to high-frequency (daily or monthly) movements in short-term rates. We find that, since 2000, this high-frequency sensitivity has grown even stronger in U.S. data. By contrast, the association between low-frequency changes (at six- or twelve-month horizons) in short- and long-term rates, which was also strong before 2000, has weakened substantially. We show that this puzzling post-2000 combination of high-frequency “excess sensitivity” and low-frequency “decoupling” of short- and long-term rates arises because increases in short rates temporarily raise the term premium on long-term bonds, leading long rates to temporarily overreact to changes in short rates. The post-2000 frequency-dependent sensitivity of long-term rates can be understood using a model in which (i) declines in short rates lead to outward shifts in the demand for long-term bonds (for example, because some investors “reach for yield”) and (ii) the arbitrage response to these demand shifts is slow. We discuss the implications of our findings for the transmission of monetary policy and the validity of the event-study methodologies.

Keywords: interest rates, conundrum, monetary policy transmission

JEL Classification: E43, E52, G12