The effect of monetary policy regime switches on the application of different term structure models to estimate South African real spot rate curve.

Abstract

The global economy was recently brought to a standstill due to the Covid-19 pandemic. This resulted in a '1-in-100 years' stress in the global economy which saw the application of drastic monetary and fiscal policy adjustments to cushion the economy against this stress. South African bond market was also negatively affected, thus negatively affecting the ability to finance the increasing primary deficit due to increased funding costs and lower liquidity. South Africa uses inflation-indexed bonds as part of government funding; however, they are less tradable in the market, translating to inadequate bond pricing/valuation data. As such, this study aims to explore dynamism of different mathematical term-structure models during the heightened Covid-19 stress in estimating the South African inflation indexed/real spot-rate curve. This study follows previous studies on the South African inflation-indexed bonds by Reid (2009) and Mashoene et al. (2021) where Nelson-Siegel and Svensson models posed a limitation in estimating spot-rates during a period of high volatility. As such, this study explores dynamic term-structure models, which follow the Nelson-Siegel framework, and static term-structure models with the option of recalibration of model parameters to account for a change in macro-economic dynamics brought by the effect of the Covid-19 pandemic. A recalibration methodology has proven beneficial for Nelson-Siegel and Svensson term structure models for model fitting and model forecasting process during the high volatility/period of total economic shutdown due to the Covid-19 pandemic. However, no improvements were observed in the Linear-parametric and Cubic-splines term-structure models. The effect of a dynamic decay rate (λ) on the Dynamic Nelson-Siegel also did not improve the performance of the Dynamic Nelson-Siegel. As such, it is recommended that the South African national government's debt managers and other bond fund managers explore this methodology for improved/enhanced estimations of debt management risk indicators. Compared to the current econometric methodology used by the Nationally Treasury which is only able to produce two points on the entire term-structure; this methodology will enable the estimation of the entire curve and the bond pricing in longer maturities where most of government funding is based.