Yield Curve and Financial Uncertainty: Evidence Based on US Data

Melbourne Institute Working Paper No. 05/19

Date: June 2019


Efrem Castelnuovo


How do short and long term interest rates respond to a jump in financial uncertainty? We address this question by conducting a local projections analysis with US monthly data, period: 1962-2018. The state-of-the-art financial uncertainty measure proposed by Ludvigson, Ma, and Ng (2019) is found to predict movements in interest rates at different maturities. In particular, an increase in financial uncertainty is found to trigger a negative and significant response of both short and long term interest rates. The response of the short end of the yield curve (i.e., of short term interest rates) is found to be stronger than that of the long end (i.e., of long term ones). In other words, a financial uncertainty shock causes atemporary steepening of the yield curve. This result is consistent, among other interpretations, with medium-term expectations of a recovery in real activity after a financial uncertainty shock.

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