Predictability of the term structure of interest rates in the G7 and BRICS countries : Application of the Expectations Hypothesis

M Com (Economics), North-West University, Vaal Triangle CampusThe predictive ability of the term structure of interest rates is tested by way of applying the expectations hypothesis in BRICS and G7 countries. The study compares the validity of the expectations hypothesis of the term structure in each country and also according to the country’s respective group. An effort to assess the effect of the financial crisis on the term structures of the countries is made to check whether or not it may contribute to the expectations hypothesis not holding, thereby affecting the term structure’s ability to predict future interest rate movements. The Autoregressive Distributive Lag model is employed as the cointegration method and results from the individual and the grouped countries are compared. Sample period consists of 157 monthly observations from May 2003 to May 2016 using the 90-day Treasury yield rate and the 10-year government bond. The study shows that the expectations hypothesis holds in China, India, South Africa, Canada, France and Germany, and it also provides evidence suggesting that in these countries the short term interest rate is able to predict the long term interest rate in the long-run. The results provide further evidence as suggested by the validity of the expectations hypothesis that, monetary policy is able to influence decision making in the economy through changing the short term interest rate and expectations in the market, ultimately influencing the long rate. The United Kingdom and the United States provides inconclusive evidence of the expectations hypothesis and the predictive ability of each of the country’s term structures. Brazil, Italy, Japan and Russia provide no evidence supporting the expectations hypothesis and the term structure’s ability to predict future interest rate movements in the respective countries. Interest rates in these countries indicate sharp volatility during and after the financial crisis when compared to countries where the expectations hypothesis holds. The financial crisis delayed the adjustment process for the developed countries compared to the developing countries. The expectations hypothesis holds in both the pooled BRICS and G7 country groups. The short rate is able to predict the long rate in both the BRICS and G7 countries, interest rates in BRICS indicate rapid adjustment back to equilibrium in the short-run; while the adjustment is sluggish in the G7 bloc. Based on the outcome of the study, the sluggish result in the G7 gives the impression that the financial crisis had an impact on the group’s term structure of interest rate as the G7 countries were directly affected by the crisis.Master