Wednesday, June 25, 2008

Monetary Aggregates and the Yield Curve (fg)

In the latest monthly bulletin of the ECB I found an interesting link between the growth rate of the heavily discussed M3 aggregate and the term structure of interest rates. Although M3 is still at peak levels of around 11 %, we can recognize a clear downward trend in M1 growth to 2.5% which covers currency in circulation and overnight deposits. The main components of M3, thus, are short-term deposist up to three months and other marketable instruments up to two years.

ECB staff identified that the particularly strong dynamics of short-term deposists are to a large extend a reflection of the humped-shaped character of the current yield curve. Tensions in the money market since the onset of the financial market turmoil created a hump-shaped pattern of the yield curve around the 3-month maturity. This triggered a shift into short-term deposits and was encouraged by the fact that with an overall flat yield curve, there was attraction to invest in short-term papers compared to longer-term assets outside M3 as they offer greater liquidity and less risk at little cost in terms of returns (which are roughly the same).