As indicated above in Figure 3, forward rates for all countries participating in the currency union have currently essentially converged to a common “Euro” term structure. Some insights into financial markets’ assessment of the future interest rate policies of the ECB relative to earlier Bundesbank policies can potentially be gleaned by comparing this yield curve with historical German norms. To this end, a state space representation of the vector of Eurocurrency deposit rates and swap rates for German instruments maturing prior to January 1, 1999 was estimated via Kalman filtration on weekly data:
where y t is a 9 x 1 vector of 3-, 6-, and 12-month Euro-DM deposit rates and 1-7 year swap rates (excluding 6-year rates), expressed as continuously compounded yields; and zt is a 4 x 1 vector of underlying state variables.
The Euro-DM data were available from January 5, 1997, while most of the swap rate data began in June 24, 1991.22 Data for post-1998 maturities were treated as missing data, with only 3-and 6-month Euro-DM rates available for inference on the final date of July 1, 1998. The estimated state space model summarizes the time-series based information contained in the level and shape of the German term structure with regard to future term structure evolution, as well as the current assessment of the state vector conditional on pre-1999 maturities. The model was used to address two questions:
1. How does the current term structure of German swap yields compare with the German pre-1999 norm represented by the final filtered value yT|T ?
2. How does the current term structure of German forward rates compare with the future 3-month spot rates that would be predicted based upon pre-1999 norms?
Figure 6 shows the actual and fitted yield curves, as well as 95% confidence intervals around the fits. The current DM yield curve is flatter than that which would be predicted based up historical German swap rates over 1991-1998 and given current short-term interest rates. The divergence is statistically significant at longer maturities. However, it should be recognized that the fits for longer maturities are based upon term structure relationships estimated on increasingly narrower subsets of the 1991-97 swap data interval, given the deliberate exclusion of swaps with payments beyond January 1, 1999.
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Figure 7 presents a different picture of future interest rate prospects. The German 3-month interest rate is stationary but highly persistent, with a weekly autocorrelation of .9969 over 1977-98. Based upon current and recent German term structures for pre-1999 maturities, the state space model would forecast gradual mean reversion in German rates back to a steady-state level of 4.75%. The current “unusually” flat Euro forward rate curve is largely consistent with that forecast. By contrast, the forward rate curve consistent with the fitted “German” yield curve of Figure 6 implicitly forecasts considerably faster increases in future German rates.
In summary, the current Euro term structure is unusually flat by German standards, but that flatness is consistent with how German short-term rates have historically evolved. This suggests that German term structures have historically been inconsistent with German short-term rate evolution (a hypothesis supported by the short-maturity rejections of German forward rate unbiasedness in Table IA above), but doesn’t answer the question of how ECB monetary policies are likely to compare with past Bundesbank policies. At present, the only evidence we have is from exchange markets, and even that has multiple interpretations. The overall declines in German and European interest rates over 1996-98 have accompanied substantial weakening of the EMU currencies against the dollar. However, those could be interpreted either as a vote of no confidence in future ECB policies, or as an expectation of future economic recession.