“Why Do Term Structures in Different Currencies Comove?” by Chotibhak (Pab) Jotikasthira
Chotibhak (Pab) Jotikasthira
The University of North Carolina at Chapel Hill
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. In a no-arbitrage vector autoregressive framework, we employ deviations from the expectations hypothesis to identify the two transmission channels, with particular attention to the degree to which each channel contributes to the co-variation among term structures across the U.S., the U.K., and Germany. We find that a world inflation factor and shocks to U.S. monetary policy together explain a sizable fraction of the co-variance of yields at all maturities between the U.S. and the U.K., as well as between the U.S. and Germany. Further, we find that these effects operate largely through the risk compensation channel for long-term bonds.