Short-term and long-term interest rate spread’s dynamics to risk and the yield curve

The yield curve is perceived to be an indicator of the future state of the economy. For example, an inverted yield curve is considered to be a signal of a forthcoming economic slowdown. Does risk explain the slope of the yield curve as well? In this paper, we explore the dynamics of short-term and long-term interest rate spread to changes in risk and government debt using time-series data. Government-issued bonds are perceived to be risk-free assets. Financial intermediaries consider government-issued securities as a secondary reserve, and they are also used during open market operations. We explore the dynamics while controlling for a potential long-run common trend between the interest rate spread and government debt. We employ the bounds test for cointegration in an auto-regressive distributed lag model and evaluate impulse responses to develop insights into the dynamics. The ARDL bounds test finds evidence of cointegration between the measures interest rate spreads and government debt. A shock to government-issued bonds indicates that the short-term spread decreases, whereas the long-term spread rises by a small margin. We conjecture an upward sloping yield curve resulting from a shock to government debt. A shock to the financial market risk index indicates that the short-term spread decreases for a brief period before returning to its pre-shock level, whereas the long-term spread more or less remains unchanged. We conjecture a downward sloping yield curve resulting from a shock to risk. This conjecture on the impact of risk on short-term and long-term interest rate spreads make the prediction about the inverted yield curve based on the expectation hypothesis and the segmented market theory somewhat weak.