Does High Yield Spread Dampen Economic Growth?: The Case of US-Japan

Abstract

This article focuses on the empirical relationship between the US' and Japan's yield spread of interest rates and economic growth in Japan. The yield spread is defined in this article as the difference between the Japanese government bond yields minus the US government bond yield. Some studies have tackled this issue and found a negative relationship between the yield spread and economic growth; however, recent studies have shown no or a weak relationship. This problem has not yet reached consensus in spite of its importance. As the Japanese interest rate has been quite low since the adoption of the zero interest rate policy at the end of 1990s, the situation may change the results. The empirical results show that reliability of yield spread as a leading indicator of output growth exists in Japan; however, term structure of interest rate is not related to output growth.

Headnote

Abstract

This article focuses on the empirical relationship between the United States' and Japan's yield spread of interest rates and economic growth in Japan. The yield spread is defined in this article as the difference between the Japanese government bond yield minus the US government bond yield. Some studies have tackled this issue and found a negative relationship between the yield spread and economic growth; however, recent studies have shown no or a weak relationship. This problem has not yet reached consensus in spite of its importance. As the Japanese interest rate has been quite low since the adoption of the zero interest rate policy at the end of 1990s, the situation may change the results. The empirical results show that reliability of yield spread as a leading indicator of output growth exists in Japan; however, term structure of interest rate is not related to output growth.

Keywords: Economic Growth; Interest Rate; Yield Spread.

JEL code: G12; G15

© 2014 Published by SSBFNET

1. Introduction

This study focuses on this issue for the Japanese case. Japan experienced severe economic conditions after the bubble economy burst in mid-1991. Before that, asset prices (e.g., stock and land) rose greatly. In 1999, the Bank of Japan (BOJ), the Japanese central bank, introduced a new and unprecedented monetary policy: the zero interest rate policy. The BOJ judged that Japan's macroeconomic indicators had come to a pause, so it adopted a policy of maintaining interest rates at an unprecedented low or zero level. Also, Japan's experience with the quantitative easing policy by the BOJ dates back to 2001. Following a period of zero interest rate policy in 1999-2000, the BOJ introduced a quantitative easing policy in March 2001.

The main operating target for market operations changed from the uncollateralized overnight interbank call rate to the outstanding balance of the current account at the BOJ. Under this quantitative easing policy, the BOJ conducted purchases of Japanese government bonds as the main instrument by which to reach its target of current account balances held by financial institutions (e.g., banks) at the BOJ while keeping interest rates at the zero lower bound. This policy's aim could be understood from the perspective that its holding an adequate level of reserves would transmit into more lending to Japanese economy (companies and consumers), promotion of increases in asset prices (i.e., stocks, etc.), and recovery from deflationary pressures. After that, the BOJ decided to end the quantitative easing policy in March 2006. However, subprime problems occurred in 2007 and the Lehman shock occurred in 2008. This influence of these occurrences on Japan was transmitted with a time lag. The Japanese yen appreciated greatly against other currencies, which hit the Japanese economy sharply. The Japanese economy depends on exports in general, so the economy was seriously damaged. In April 2013, the Policy Board of the BOJ decided to adopt quantitative and qualitative monetary easing. The BOJ decided to achieve the price target of 2% in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest time. To achieve quantitative monetary easing, the main target of monetary policy instruments was changed from the uncollateralized overnight call (interbank interest) rate to the monetary base to cooperate closely with the government. The Japanese experiences should be analyzed much more as Japan experienced recession and deflation for more than twenty years and unprecedented monetary policies were first introduced there. Also, in most industrialized countries, interest rates have been becoming quite low in recent years. An examination of the relationship between interest rate yield spread and economic growth becomes more important than ever before.

This article focuses empirically on the relationship between the US and Japan yield spread and economic growth rate in Japan. Many studies have examined the term structures; however, few studies have focused on yield spread, especially on the US-Japanese case. This article is structured as follows. After this section 1, this article provides empirical analysis in section 2. Section 3 provides the results, analyzes those of section 2, and shows the results of further analysis. Finally, this article ends with a brief summary.

2. Literature Review

According to the traditional theory of economics, there exists negative relationship between high yield spreads and economic activity. Economic theory teaches that high yield spreads include information about the credit risk, especially, default risk, on bonds issued by a lower ranked government (Wright, 2006). Default risk is usually likely to be negatively related to economic crises or bad macroeconomic conditions. This seems to be the most understandable and common view. The evaluation and appropriate use of the yield spread would be necessary not only for the participants of financial markets who would like to use information effectively but also for policymakers to conduct economic policies.

In reality, most studies have supported the view that higher spread yields dampen economic growth. A high yield spread impacts lending/borrowing rates and thereby industrial/consumer outperformance and its expectation and overall economic activity negatively. Zuliu (1993) showed that the slope of the yield spread becomes a valuable predictor of economic growth of the future for G7 countries' government bond markets. This study also indicated that the yield spread could be a better predictor than stock price, based on a theoretical model and a univariate time series empirical model. Bange (1996) suggested that the term structure and expected inflation changes information about future economic growth. Estrella and Mishkin (1996) found that the yield curve is a good predicting indicator of output. Estrella and Hardouvelis (1991) found that a positive slope of the yield curve is related to a future increase in real economic activity, consumption, consumer durables, and investment. Also, the term spread has more influence on forecasts of the future growth rate than marginal growth in future periods. Gertler and Cara (1999) and Moody & Taylor (2004) found that the yield spread is significant predicting indicator for real economic activity for the United States. Paya, Venetis, and Peel (2004) suggested that the yield spread is one of the most important forecasting predictors of future output changes. Also, Paya et al. found that the yield spread outperforms other predicting indicators for outputs such as money, stock prices, and interest rates. Lackshman (2008) showed that the term spread has significant power to forecast real output growth. Periklis and Ioannis (2012) found the yield curve augmented with nonmonetary variables also has significant forecasting power for future economic activity, but the results were different for individual economies and policy implications. Azamat (2013) showed that term spread has forecasting power as a predictor of future output; however, this study showed that there also is a gain from the use of information in the curvature factors.

However, Plosser and Rouwenhorst (1994) showed that foreign term structures of foreign countries can forecast domestic low frequency movements in real economic activities especially for countries that are under high and volatile inflation rates. Hamilton and Kim (2002) demonstrated that although the volatility of economic variables correlaties with both the term structure of interest rates and output, this study does not explain the yield spread's effectiveness in predicting output growth. Benati and Goodheart (2008) found that yield spread does not have predictive power for output growth and monetary policy. Recently, the relationship between yield spread and output has received significant focus in the literature. De Pace (2013) and De Pace and Weber (2013) found that high yield spreads are unreliable as leading indicators and cast doubts on the existence of a functioning financial accelerator in recent years. Mohapi and Both (2013) demonstrated a weak relationship between term spread and output growth. Saymeh and Orabi (2013) found that the so-called current interest rate may influence output growth rates.

Some studies have focused on the relationship between the term structure and economic variables. The typical economic variable is inflation (rate). Lynch and Ewing (1998) demonstrated that increases in uncertainty about the economy relative to the future path of inflation incur a wide spread between short-term and long-term interest rates in Japan. Bhar and Hamori (2007) showed that economies in which people prefer low-risk investments are more likely to prefer a low volatility asset position over a high volatility one, whereas economoies in which people prefer high rish are more likely to prefer a high volatility position over a low volatility position.

In general, the negative effect relationship has been supported mainly by past studies; however, recently, some studies have cast doubts on this relationship, which has result in an animated debate about the rate of interest rate spread in influencing real economic activities. The world economy experienced drastic and serious economic crisis starting in the 1980s and several times during ongoing financial globalization and huge capital movements. The focus on the roles and function of financial markets has been addressed in the research. Also, most developed economies experienced recession or low growth starting in the 2000s. Some countries, including Japan, still suffer deflationary pressures. To recover and boost the economy, there should be a large possibility to manage and see the forecasting power of the yield spread not only for Japan but also for other countries. Moreover, many studies have analyzed the interest rate term structure; however, few have examined yield spread.

3. Reseach and Methodology

The purpose of this study is to examine empirically the recent relationship between the yield spread and economic growth in Japan. The basic estimation equation is the estimation of (1). A standard reduced form is estimated to predict real GDP by the yield spread in this study.

First, statistical data for each variable are shown in Table 1.

(ProQuest: ... denotes formula omitted.)

where GR denotes growth rate of real GDP. SP means yield spread. Three kinds of yield spread are used for estimation. SPn (n = 1, 2, and 3) is defined as follows.

SP1: Japanese long-term government bond yield - US long-term government bond yield

SP2: Japanese short-term government bond yield - US short-term government bond yield

SP3: Japanese long-term government bond yield - Japanese short-term government bond yield

Quarterly data are used for estimation. The sample period is from 1992 to the end of 2013. Economic waves occurred during that period; however, the economic situation was not good. After the bubble economy burst in 1991, the so- called lost 20 years began and continues even now. The long-term Japanese government bond is 10 years and the short one is one year. All of the data are from International Financial Statistics (International Monetary Fund). Using equation (1), empirical analysis is conducted in the next section. Empirical methods are OLS (ordinary least squared) and GMM (generalized method of moment).

4. Empirical Results and Further Analysis

The empirical results are shown in Table 2. One empirical method is OLS. However, one problem in equations of this kind is the existence of unobservable specific effects and also lagged dependent variables. This problem can be overcome with the use of the GMM method, which is often used for this purpose. This method requires a decision on which variables to use as instrumental variables. In this equation, the lagged values of the dependent variables are used as instrumental variables. Equation (A) in the table is re-estimated using GMM [the result is (D)] as this result is better than those produced by equations (B) and (C).

It is absolutely clear that the cases of (A) and (D) are pretty good. It is interesting to note that the yield spread exists in recent financial markets in Japan against the recent trends of academic studies. Moreover, the case of term structure [i.e., equation (B) in the table] does not fit well. Equation (C) also does not fit well. Further analysis on these points is performed later.

Instead of the variables SP1, SP2, and SP3, yield spread of equations (A), (B), and (C), and the rating of Japanese government bond by three worldwide rating agencies' indexes are used for the estimation. A rating agency is a company that provides credit ratings, or, more concretely, ratings of debtors' ability to pay back the debt by making timely interest payments and of the possibility of default. Recent ratings for Japan are shown in Table 3.

The rating on the left side of the equation is indexed from 1 (lowest) to 6 (highest) for the estimation. The empirical results are shown in Table 4. Only the case of equation (A) is examined. The ratings of each agency ratings are used for estimation instead of SP1 in equation (1).

Moreover, VARs are employed for further analysis. This method is commonly used to forecast systems of interrelated time series and to analyze the dynamic impact of random disturbances on the variables used. Empirical estimation and interface are complicated by the fact that endogenous variables may appear on both the left and right sides of the equations. The use of VARs simultaneously allows estimations to avoid this issue. The variables are the long-term yield spread, short-term spread, and economic growth. Two time lags are employed for estimation. The results and the impulse response are as shown in Table 5 and Figure 1.

Higher ratings mean good economic conditions in general, so it indicates high economic growth. The coefficients of the explanatory variables are expected to be positive and all of the coefficients satisfied this expectation. However, the results do not fit well. Not all of the coefficients are significant. However, it should be noted that the role of the agency rating is to evaluate debtors' ability to pay back the debt by making interest timely payments and of the possibility of default rather than to promote economic growth.

The results shown in Table 5 indicate that the long-term yield spread has been a leading indicator of economic growth rate. Also, Fig. 1 shows that monetary policy announcements intended to boost the economy cause yen depreciation, which promotes exports and increased stock prices. However, the time span are not so long. The results are those expected by market participants.

Finally, the method of least squares with breaks is calculated. Only the case of equation (A) is used for estimation. Bai-Perron tests are employed for the estimation; the time 2008Q1 is selected by the tests. The empirical results are as shown in Table 6.

The results also are good. In 2007, the subprime problem occurred, with the Lehman shock after that. Both damaged the world economy. Also, the quantitative easing policy and zero interest rate policy ended in 2006 in Japan. In 2010, the BOJ again introduced the zero interest rate policy. It is interesting; however, difficult to understand why 2008Q1 is selected instead of 2006 or 2010 for the breaking point. The reason may be that Japan has been influenced by the world economy, especially that of the United States. Large capital inflows into Japan and Switzerland, instead of the US dollar, occurred in spite of the fact that the Japanese economy had not been in good condition. It seems natural that not the end of the quantitative easing policy and zero interest rate policy but the effect of the subprime and Lehnman shocks on the financial markets was selected for breaking points, as the effect is very large. From another view, one might also judge that the BOJ's monetary policy was appropriate and smoothing, and it did not damage financial markets.

5. Conclusions

Economic theory teaches that high yield spreads should be related negatively to economic growth. This article found that this theory fits with recent the case of the United States and Japan, which is counter to the trend in recent academic studies. Yield spread is one of the indicators of economic growth. On the other hand, the relationship between the term structure of the interest rate and economic growth was not found. Also, this study found that the period of the Lehman shock influenced the relationship between yield spread and economic output. The breaking point was found in 2008Q1 during the period of 1992Q1 to 2013Q4.

Studies about yield spread are not adequate. The case of Japan is not an exception. Such studies could be related to appropriate monetary policy to create sound financial markets. Much more analysis and discussion is needed.

*Publication of this article was supported by a grant-in-aid from Zengin Foundation for Studies on Economics and Finance.

References

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