Abstract

We model the dynamics of the euro area yield curve using a shadow-rate term structure model (SRTSM), with particular attention to the period since late 2011 when interest rates have been at the lowest level since the inception of EMU. The shadow rate is driven by latent factors with linear Gaussian dynamics, while the actual short rate is the maximum between the shadow rate and a lower bound so that interest rates will never fall below that level. The estimated SRTSM performs attractively with respect to cross-sectional t and forecast performance. The model implies that since mid-2012 the median horizon when future one-month rates would return to 50 bps has been ranging between about 25 and 40 months. Deriving such lift-off timing instead from the simple metric of the forward curve crossing 50 bps would underestimate the SRTSM-implied median timing by between 5 to 15 months. As a novelty in the literature, we analyze the effect of a downward shift in the lower bound on the yield curve: for short maturities, rates decrease one-to-one with a drop in the lower bound, while the effect diminishes for longer maturities. Empirically, the term structure movements since early 2014 suggest that there have been two downward shifts in the perceived lower bounds, which were associated with the two decreases of the ECB's deposit facility rate to minus 10 and minus 20 basis points, respectively.

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