from the St Louis Fed
The fact that interest rates on government bonds fell during the financial crisis wasn’t surprising. The fact that they haven’t rebounded during the subsequent recovery may be.
In the third part of an Economic Synopses essay series, Economist Julian Kozlowski examined how the increase in tail risk – or the risk that the economy will suffer extreme negative shocks – may be playing a role in continued low-interest rates on government bonds.
Kozlowski focused on two key attributes of government bonds:
- Safety: The default risk of U.S. government bonds is nearly zero.
- Liquidity: U.S. government bonds can be sold prior to maturity with nearly no discount.
Liquidity
Liquidity becomes especially important during periods of financial distress. The liquidity of many other assets falls during these periods, making government bonds more valuable, Kozlowski explained.
Liquidity can also be important to guard against the perception that a risky event will happen. He noted that the perceived probability of such an event – in this case, a period of financial distress – increased substantially following the Great Recession.
“The increase in tail risk implies that the liquidity of government bonds is even more valuable after the Great Recession,” Kozlowski wrote. “Consequently, the increase in liquidity needs caused an increase in the price and a decrease in the return of government bonds after the Financial Crisis.”
Measuring Tail Risk’s Impact
In a recent working paper, Kozlowski and co-authors Laura Veldkamp and Venky Venkateswaran constructed a model to measure the impact of the change in tail risk on government bonds’ liquidity and return.1 Their model showed that the risk-free rate never quite recovers from the negative shocks of the Great Recession.
Notes and References
1 Kozlowski, Julian; Veldkamp, Laura; and Venkateswaran, Venky. “The Tail that Keeps the Riskless Rate Low.” NBER Working Paper No. 24362, February 2018.
Additional Resources
- Economic Synopses: Tail Risk: Part 3, The Return on Safe and Liquid Assets
- On the Economy: The Connection between Corporate Bond Maturities and Projected GDP Growth
Source
https://www.stlouisfed.org/on-the-economy/2020/february/effect-tail-risk-government-bond-liquidity
Disclaimer
Views expressed are not necessarily those of the Federal Reserve Bank of St. Louis or of the Federal Reserve System.
