In February 2005, Fed’s Chairman Alan Greenspan wondered why the long end of the yield curve did not show any reaction to the hiking prime rate. Normally, a hiking prime rate gets through the complex transmittance-mechanism to the long end of a yield curve. But in this cycle since June 2004, nothing changed at the long end. An explanation via the classic interest theories does not come to a satisfiying result, so the situation must be explained by the actual circumstances.
The main reason is a very high liquidity which has its origin in the last economic cycle. The excessive investments in 1999 and 2000 still keep the enterprises busy. They do not invest in fixed assets, which would mean a higher capital demand, but on the capital market; and they pay back their debts, which also leads to a falling yield.
The liquidity supply from east asia causes a high demand for US-$ - bonds as well. China for example holds more than one trillion US-$ as monetary reserve to keep their exchange rate low.
A combination of many more, different facts, which deserve closer attention, lead to the answer to Greenspan’s conundrum.
Table of Contents
1. Introduction
2. The Yield Curve: Basics
3. Theories of the Transmittance in the Yield Curve
3.1. Fisher’s Theory of Interest
3.2. Hicks’ Liquidity-Preference-Theory
3.3. Culbertson’s Segmentation Theory
3.4. Preferred-Habitat-Theory
3.5. Summary
4. Description of the Actual Situation
5. Reasons for the Deviation from the Theories
5.1. Expectation-Determined Factors
5.2. Liquidity Factors
5.3. Structural Factors
5.4. The Comprehension of the Central Bank
6. Conclusion
Research Objectives and Topics
The primary objective of this paper is to examine the "Greenspan conundrum"—the phenomenon where long-term interest rates failed to rise despite a series of short-term interest rate hikes by the Federal Reserve. The study investigates why traditional interest rate theories failed to explain this market behavior and identifies the underlying structural and liquidity-driven factors contributing to this decoupling.
- Theoretical foundations of yield curve transmittance.
- Impact of global liquidity and capital supply.
- Influence of Asian central bank reserves and energy market profits.
- The evolving credibility and role of central banks in managing inflation expectations.
Excerpt from the Book
3.2. Hicks’ Liquidity-Preference-Theory
A more realistic theory of the yield curve is Hicks’ theory. Its main conclusion is that investors will not buy a long-term bond without a risk-bonus. This bonus is finally the reason why the rate at the long end of the yield curve is normally higher than at the short end (Brinkmann, 2005, p. 50).
In his theory, Hicks presumes that decisions for the future are flawed with insecurity, so an investor would only buy long-term bonds if his insecurity is compensated by a higher interest payment. If the investor’s insecurity is not compensated, he would only invest in short-term bonds to minimize the risk of losing his capital. Another assumption of Hicks is that an prefers capital safety to income safety. This means that it is more important not to suffer capital loss than to earn a higher yield.
Hicks also assumes, in contrast to Fisher, that investors have to pay transaction costs. For investing his money for ten years, the investor would pay much more transaction fees if he buys ten yearlong bonds than if he invests in one decennial bond (Hicks, 1947, p. 130 et sqq.). From this follows, that the long term yield can not be the geometric average of the short term yield – the short term rates have to be higher to compensate the transaction costs. Another fact which Hicks adds is that if the short term rate is lower than the transaction costs, no investor would buy short term bonds – he just wants to earn a net-income. (Brinkmann, 2005, p. 52)
Chapter Summary
1. Introduction: This chapter introduces the "Greenspan conundrum," focusing on the surprising lack of response of long-term capital market rates to Federal Reserve short-term rate hikes.
2. The Yield Curve: Basics: This section defines the yield curve as a graphical representation of interest rates across different maturities and explains how central banks attempt to influence it via prime rates.
3. Theories of the Transmittance in the Yield Curve: This chapter reviews classical economic theories—including those by Fisher, Hicks, and Culbertson—to explain how short-term rate changes are supposed to be transmitted to long-term rates.
4. Description of the Actual Situation: The author details the specific market conditions observed in 2005-2007, highlighting the divergence between rising prime rates and the inverted yield curve.
5. Reasons for the Deviation from the Theories: This chapter analyzes potential causes for the failure of traditional theories, including market expectations, global liquidity gluts, structural factors like Asian currency reserves, and central bank credibility.
6. Conclusion: The paper summarizes the findings, noting that no single theory can explain the conundrum and that a combination of factors, such as high global liquidity and structural shifts in capital demand, are responsible.
Keywords
Yield Curve, Greenspan Conundrum, Federal Reserve, Prime Rate, Interest Rate Theory, Liquidity, Investment Barrier, Capital Market, Monetary Policy, Inversion, Long-term Rates, Central Bank Credibility
Frequently Asked Questions
What is this research paper about?
The paper examines the "Greenspan conundrum," a financial phenomenon from 2005 where long-term interest rates did not increase as expected despite the Federal Reserve raising short-term interest rates.
What are the central thematic fields of this work?
The central fields include interest rate structures, monetary policy transmission mechanisms, global capital market dynamics, and the influence of international liquidity and reserve holdings on domestic yields.
What is the primary goal of the study?
The goal is to determine why traditional economic models, such as Fisher's Theory of Interest, failed to predict or explain the market behavior during the 2004–2007 hiking cycle and to provide alternative explanations.
Which scientific method is used?
The work utilizes a literature-based analysis of established economic theories and compares them against empirical financial data and current observations from the period to identify discrepancies.
What topics are covered in the main section?
The main section covers the definition of the yield curve, various transmittance theories, an analysis of the actual economic situation during the years 2005–2007, and a breakdown of reasons for theory deviation, including liquidity and structural factors.
Which keywords characterize the work?
Key terms include Yield Curve, Greenspan Conundrum, Liquidity, Prime Rate, and Monetary Policy, reflecting the intersection of central banking and global capital market behavior.
What role does the "investment barrier" play according to Rajan?
Rajan’s concept of the "investment barrier" suggests that despite healthy global growth, corporations were not investing in new fixed assets due to existing capacity, leading them to pour profits into capital markets instead, which pressured long-term yields downward.
How did Asian central banks contribute to the anomaly?
Asian central banks, particularly China, accumulated massive US-Dollar reserves to manage exchange rates, which were then reinvested into US bonds, artificially increasing the supply of capital and lowering long-term bond yields.
- Arbeit zitieren
- Christoph Müller (Autor:in), 2007, The transmittance of changes of the prime rate to the long end of the yield curve – and why it actually does not work, München, GRIN Verlag, https://www.hausarbeiten.de/document/86020
