Unveiling the asymmetric linkage between economic policy uncertainty and sovereign bond yields: a quantile ARDL approach

Abstract

Purpose This study aims to investigate the long-run relationship between domestic economic policy uncertainty (EPU) and sovereign bond yields in an emerging economy, India, by using monthly data from May 2004 to July 2023. Design/methodology/approach The link between EPU and sovereign bond yields is examined through the quantile-ARDL approach (Cho et al., 2015). It is used to uncover the asymmetric linkages between the variables by considering different quantiles of the response variable. Findings The results provide empirical evidence that the impact of EPU on sovereign bond yields varies according to the quantile and maturity of the bond yields. EPU negatively affects short-term bond yields at all the quantiles. However, the negative impact of EPU on medium- and long-term bond yields is observed only at the lower quantiles and not at the higher quantiles. The results confirm the presence of “flight to quality,” as investors perceive government bonds as safe during uncertain time periods. Research limitations/implications The study provides useful insights for various stakeholders. Theoretically, the findings contribute to the “liquidity theory” of interest rates, as they demonstrate that investors have a higher demand for liquid assets during periods of uncertainty. Also, the findings underscore the influence of monetary policy rates on long-term yields, corroborating the “expectation theory” of the term structure of interest rates. Furthermore, amidst periods of uncertainty, policymakers can maintain clarity and transparency by communicating beforehand warning signals to stabilize market anticipations. The findings also encourage investors to optimize their portfolios by incorporating government bonds as a means of reducing the risk pertaining to financial markets. Originality/value As opposed to previous studies that primarily focused on the mean-based linear relationship between EPU and bond yields in developed economies. This study explores the asymmetric linkages between domestic EPU and government bond yields in an emerging economy context by using an advanced econometric method, namely, quantile cointegration, which considers not only the average but also the extreme quantiles.