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| Demographics and the Term Structure of Interest Rates: The Flat Yield Curve of an Elderly Society |
| LI Xue, ZHU Chao, YI Zhen
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| School of Finance, Capital University of Economics and Business |
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Abstract The slope of the yield curve is an important predictor of future economic activity. A flatter or inverted term spread often predicts low future output growth and a high probability of a recession. As an important economic signal and pricing benchmark for financial markets, the term structure of interest rates also affects investment decisions. We use demographics to study the dynamics of the yield curve. First, we discuss theoretically the channel of influence of the demographic structure. Next, we build a life-cycle model by introducing the consumption-capital asset pricing model (C-CAPM) to capture the dynamics of the yield curve. The life-cycle model allows us to capture the demographic structure and provides a general equilibrium basis for our analysis.
Our model reveals that the population structure affects the term structure of interest rates because of changes in savings over the life cycle, making demographics an important determinant of the yield curve. By influencing bond yields, the population structure has an impact on the yield curve. A young population prefers short-term bonds, which has a positive impact on the term structure of interest rates. Both middle-aged and elderly populations prefer long-term bonds, pushing down the long-term yields. Consequently, the slope of the term structure flattens with the age of the population.
The empirical evidence supports the predictions of our model. We obtain demographic data from the Health Nutrition and Population Statistics database of the World Bank and yield rate data from the International Financial Statistics database of the International Monetary Fund and the Wind database. Data on GDP, inflation and other economic variables come from the World Development Indicators dataset of the World Bank. Our sample includes 58 years of annual data from 194 countries or regions. We find that the term spread increases with the proportion of youth in an economy and that the proportions of middle-aged and elderly individuals have the opposite effect. The term spread is smaller and the yield curve is flatter in an older economy. These findings are robust to alternative population structure variables, term spread variables, estimation methods and sample weights.
The contributions of this paper are as follows. First, our theoretical model combines the life-cycle model and C-CAPM to examine how demographics relate to interest rates. Numerous studies focus on the impact of macroeconomic variables such as output and prices on the term structure of interest rates. We extend the literature by focusing on demographics as the driving force of the yield curve. In addition, we provide empirical evidence of the relationship between the population structure and the yield curve using various age structure variables, multi-dimensional yield curves (level and slope) and empirical models.
The second contribution is an interesting finding regarding the relationship between demographics and the yield curve. The theoretical and empirical evidence suggests that older economies may have higher short-term interest rates and lower long-term interest rates, leading to a relatively flat yield curve. A common concern is that an inverted yield curve might forecast an economic recession. However, a flat yield curve can stimulate long-term investment. In this sense, an increase in the age of the population can have a positive effect on long-term economic development.
The world's population is aging. Financial markets will respond to this change accordingly. Understanding the dynamic relationship between the yield curve and macroeconomic variables is of great importance. Our study provides investors with advice on how to judge market price distortions in the future. China's central bank, the People's Bank of China (PBOC), has recently lowered thereserve ratio. The new loan prime rate (LPR) is linked to interest rates set during open market operations, namely the PBOC’s medium-term lending facility. This change is meant to improve financial support and reduce the capital cost of the real economy. To further reduce interest rates, especially the long-term interest rate, the LPR interest rate mechanism should be used to increase the difference in interest rate policies, crack down on short-term speculation, encourage long-term investment and guide the development of the financial sector to coordinate with economic and social development. The population is always an important factor in economic development. Increasing the fertility rate and reducing the average age can revert the term structure of interest rates to a normal shape in the long run, improve the vitality of the economy and reduce the probability of an economic recession.
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Received: 04 March 2019
Published: 02 July 2020
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