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The Financial Crisis and the Dynamics of the Money Market Rates

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The Financial Crisis and the Dynamics of the Money Market Rates A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Hasler, Nicole Research Report The financial crisis and the dynamics of the money market rates WWZ Forschungsbericht, No. 2014/08 Provided in Cooperation with: Center of Business and Economics (WWZ), University of Basel Suggested Citation: Hasler, Nicole (2014) : The financial crisis and the dynamics of the money market rates, WWZ Forschungsbericht, No. 2014/08, Universität Basel, Wirtschaftswissenschaftliches Zentrum (WWZ), Basel This Version is available at: http://hdl.handle.net/10419/127548 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu Wirtschaftswissenschaftliches Zentrum (WWZ) der Universität Basel September 2014 The financial crisis and the dynamics of the money market rates WWZ Forschungsbericht 2014/08 (FV-24) Nicole Hasler Wirtschaftswissenschaftliches Zentrum (WWZ) der Universität Basel Die Autorin: Nicole Hasler Abteilung Finanzmarkttheorie Wirtschaftswissenschaftliches Zentrum der Universität Basel (WWZ) Peter Merian-Weg 6 CH - 4002 Basel Telefon: +41(0)61 267 05 23 [email protected] Eine Publikation des Wirtschaftswissenschaftlichen Zentrums (WWZ) der Universität Basel. Diese Publikation und das in ihr dargestellte Forschungsprojekt wurden durch den Förderverein des WWZ finanziell unterstützt. WWZ Forum 2014 und des Autors / der Autoren. Eine Reproduktion über die persönliche Nutzung des Papiers in Forschung und Lehre hinaus bedarf der Zustimmung des Autors / der Autoren. Kontakt: WWZ Forum | Peter Merian-Weg 6 | CH-4002 Basel | [email protected] | www.wwz.unibas.ch The financial crisis and the dynamics of the money market rates Nicole Hasler∗ 8th September 2014 Abstract This paper contributes to the ongoing debate about the changing dynamics in the money market rates after 2007. It aims to analyse the interest rate channel of monetary policy transmission until the federal funds target rate reached the zero lower bound. A set of different model explains both long and short run dynamics of U.S. money market rates up to 6 months. I find that secured money market rates move together with monetary policy expectations whereas unsecured interbank rates disconnected from policy rates due to an increase in both credit and liquidity risks. JEL-Classification: E43; E52; E58 Keywords: Transmission of Monetary Policy, Financial Crisis, Money Market ∗University of Basel, Faculty of Business and Economics, Peter-Merian-Weg 6, 4002 Basel, Switzerland, [email protected] 1 Contents 1 Introduction 1 2 Literature Review 2 2.1 Money market spreads and the financial crisis . 3 2.2 Monetary policy transmission and implementation prior to the crisis . 4 2.2.1 Expectation hypothesis and the money market rates . 4 2.2.2 Federal funds rate dynamics . 5 3 Data and preliminary tests 6 3.1 Order of integration . 9 4 Empirical analysis 10 4.1 Bivariate VECM . 10 4.2 EGARCH model with error correction term . 12 4.3 VAR on levels . 17 5 Findings 18 5.1 Co-movements of the money market spreads: 2007 to 2008 . 18 5.2 Transmission of monetary policy and money market volatility: 2003 to 2008 . 21 5.3 Dynamics of the interbank rates after a shock: 2007 to 2008 . 24 6 Conclusion 25 Bibliography 27 A Appendix I A.1 Variables . I A.2 Unit root and stationarity tests . II A.3 Single regression cointegration tests . IV A.4 Johansen methodology . VII A.5 Granger causality tests . IX A.6 Impulse response functions . X A.7 Variance decomposition . XI List of Figures 1 3months maturity spreads (in bps) . 1 2 Rates at 3months maturity (in bps) and the Tbill-OIS spread . 6 3 LOIS spread at 3months maturity (in bps) and risk measures . 8 2 List of Tables 1 Order of integration during the crisis . 9 2 List of exogenous variables for the VECM . 11 3 List of variables in EGARCH model . 16 4 VECM spreads without exogenous variables . 19 5 VECM spreads with exogenous variables . 19 6 VECM: Exogenous variables . 19 7 Long-run relationship based on DOLS estimates . 21 8 Results EGARCH with error correction term . 23 9 List of variables . I 10 Summary of UR and stationarity testing . III 11 Single cointegration regression testing for the spreads . IV 12 Single cointegration regression testing for the unsecured interbank rates w/o RP V 13 Single cointegration regression testing for the unsecured interbank rates w/ RP . VI 14 Johansen test for the spreads . VII 15 Granger causality tests for VAR . IX 16 Responses of Libor of 1, 3 and 6 months . X 17 Responses of 1week Libor . X 18 Responses of CD rate of 1, 3 and 6 months . X 19 Responses of ED rate of 1, 3 and 6 months . X 20 Variance decomposition LIBOR models . XI 21 Variance decomposition VAR models . XI 3 1 Introduction The subprime crisis triggered a global financial crisis and severely impaired the functioning of the unsecured interbank market in 2007. This has caused serious disruptions in the transmission of monetary policy. Unsecured interbank rates decoupled from monetary policy. The U.S. Federal Reserve Bank (Fed) responded with severe target rate cuts and launched a series of non- standard monetary policy measures to improve the funding conditions in the interbank market. Therefore, the Fed closely tracked the Libor - Overnight Index Swap (LOIS) spread as a measure how interbank rates responded relative to expected monetary policy rates. Alternatively, the TED spread, the Libor over the risk-free Treasury bill (Tbill), provides another measure of money market stress. However, this measure also covers the flight-to-safety effect in government securities. Figure 1 outlines the movements of the two spreads over time. From visual inspection it can be inferred that both spreads were both small prior to the crisis. Especially, the LOIS spread was very small prior to August 2007, whereas the TED spread appears to be larger. What becomes evident from this Figure is that both spreads follow a different pattern after autumn 2008 and when the zero lower bound (ZLB) in December 2008 was reached. 2005 2006 2007 2008 2009 2010 2011 5 TED spread LOIS spread 4 Target rate 3 2 1 0 Figure 1: 3months maturity spreads (in bps) The main objective of this paper is to evaluate the interest rate channel and to understand the dynamics in the money market in a crisis environment. I focus on the time period until December 2008 and analyse both the short and long-run adjustment of different money market instruments up to 6 months maturity. With respect to crisis and pre-crisis literature, I employ three different empirical models to evaluate how the interest rate channel is affected in an environment of high uncertainty about funding conditions. First, in line with the crisis literature, I examine the interrelationship between Libor spreads during the financial crisis and how they respond to policy announcements. I find that Libor spreads co-move during the crisis period up to 6 months maturity due to the link between monetary policy expectations and secured interbank rates. Second, similar to pre-crisis pass- 1 through models, I investigate the interest rate channel by estimating the long-run relationship of unsecured interbank rates, monetary policy expectations, and risks. I find that the relationship deteriorated since rates are subject to additional drivers such as credit and liquidity risk. The third approach concentrates on the dynamics of the interbank rates during the crisis. I investigate how interbank rates respond to monetary policy, liquidity and credit risk shocks. Findings show that the interbank rate respond to the shocks in credit risk and monetary policy expectations. The remainder of this paper is organised as follows. In Section 2 I briefly summarise the literature about monetary policy transmission both prior and during the crisis. Section 3 presents the data and preliminary tests. Section 4 documents the empirical analysis including three different econometric approaches. Section 5 documents and discusses the findings. Finally, section 6 concludes. 2 Literature Review The money markets play a crucial role in the transmission of monetary policy. By controlling the amount of reserves, most central banks set a short-term rate and rates at the longer end of the yield curve convey information about expected path of monetary policy. The concept of the expectation hypothesis explains how interest rates are tied together. In the U.S., the effective federal funds rate is the average overnight rate at which regulated financial institution lend balances among each other to meet their reserve requirements1 at the Fed. The central bank announces a price for these reserves, the overnight federal funds target rate. Through the implementation of the monetary policy such as open market operations (OMO), temporary or permanent, the Fed determines the level of reserves and therefore steers the level of the effective federal funds rate. The next step is that expectations about future changes in the overnight rate affect the level of longer-term interest rates such as the Libor.
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