The yield curve and the macroeconomy: Evidence from Turkey

a r t i c l e i n f o JEL classification: G1 E4 C5 Keywords: Term structure Yield curve Monetary policy Macroeconomics This paper contributes to the literature on the relationship between the yield curve and macroeconomic variables by focusing on an emerging market case: Turkey. The most important result of the paper is that the relationship between the yield curve and macroeconomic variables is significantly affected by the change in monetary policy which is associated with the implementation of inflation targeting (IT) regime. While before the IT regime the yield curve is affected to some extent by macroeconomic variables, after the IT regime, it is mainly driven by macroeconomic variables. We also find that central bank has gained ability to affect the entire yield curve with the IT regime. The other important result is that in addition to inflation and real activities , the exchange rates also play an important role in the yield curve dynamics in Turkey. The recent events reveal the close feedback between the real economy and financial conditions, and push macroeconomists, finance economists and policymakers into a significant challenge that the macro-finance linkages need to be well established. Given that the short-term interest rate is at the interconnection of the finance and the macro literature, investigation of the term structure of interest rates and inspecting the role of macroeconomic variables in the yield curve movements can be considered as a good start for this purpose. Until recently, in the canonical finance models, which are started by Vasicek (1977) and Cox et al. (1985), characterized by Duffie and Kan (1996) and classified by Dai and Singleton (2000), the short-term interest rate is described as an affine function of a few latent factors. In a similar fashion, the long-term interest rates are related to those same latent factors and movements in the long-term yields are mainly driven by the change in risk premiums. In this approach, the role of the macroeconomic dynamics is almost completely ignored and it is left unspecified the link between the latent factors and macroeconomic variables. On the other hand, in the macro literature, the short rate is determined by the deviations of inflation and output from targets set by central banks and the long-term interest rates are mainly determined by the expectations of future short-term interest rates. In this approach, financial frictions, the yield spreads for credit or liquidity risk …