Analysis of the government bond market and monetary policy

• At certain points of time, the yield curve shapes, representing a time-varying relationship of the interest rate and maturity, and their slopes are of great significance for various economic and financial decisions.

• The term structure model that integrates macroeconomic and stock market factors in the state-space framework is used to evaluate the policy shocks through the short, medium, and long-term bond yields to the real economy.

• The findings will give an insight and policy guidelines for the central bank in the current version of monetary policies. It will measure the effect of recent ample liquidity on the long-term interest rates, inflationary expectations, and economic activity.

This study evaluates the informational contents of the yield curve for policy analysis in the context of emerging markets, where the market suffers from the lack of liquidity and the government relies heavily on bond financing to finance deficits. Particularly, we are interested to determine the transition mechanism through which the monetary policy affects the real economy and the financial sector. This study formulates a yield curve model that integrates monetary policy as well as real economy factors in the term structure model; while simultaneously taking into account the international financial transmission of shocks from the developed markets to the emerging ones.

The focus of the study is to find out the more appropriate model for predicting the stances of monetary policy on the term structure of interest rate and the possible feedback on the real sector and equity market.  Furthermore, the modeling approach will be able to determine the impact and transmission mechanism of external shocks on the domestic economy yield curve. The study also identifies if these fluctuations in the short-term rates will translate and transmit to the long end of yield curve, which in turn may cause a fluctuation in the real sector and long-run dynamics of the economy.

The preliminary findings of the study show that volatility in various maturities yields correspond to the monetary and fiscal policy regimes in Pakistan. It shows that the yield curve responds to the stances of monetary policy and might transmit the signals of monetary interventions to the real sector through the alteration in the slope or/and the curvature of yield curve. Therefore, the joint interaction of yield curve factors and the macroeconomy will be useful to evaluate the impact of monetary and fiscal policies on the yield curve and feedback effects on the real sector and foreign exchange market.