Most
investors care about future interest rates, but none more than
bondholders. If you are considering a bond
or bond fund investment, you must ask yourself whether
you think interest rates will rise in the future. If the
answer is yes then you probably want to avoid long-term
maturity bonds or at least shorten the average duration
of your bond holdings; or plan to weather the ensuing price
decline by holding your bonds and collecting the par value at
maturity. (For a review of the relationships between
prevailing interest rates and yield, duration, and other bond
aspects, please see the tutorial Advanced Bonds Concepts.)
The Treasury Yield Curve
In the
United States, the Treasury yield
curve (or term
structure) is the first mover of all domestic interest
rates and an influential factor in setting global rates.
Interest rates on all other domestic bond categories rise and
fall with Treasuries,
which are the debt securities issued by the U.S. government.
To attract investors, any bond or debt security that contains
greater risk than that of a similar Treasury bond must offer a
higher yield. For example, the 30-year mortgage rate
historically runs 1% to 2% above the yield on 30-year Treasury
bonds.
Below is a graph of the actual Treasury yield
curve as of Dec 5, 2003. It is 'normal', as it slopes upward
with a concave shape:
Consider three elements of this curve. First, it
shows nominal interest rates. Inflation
will erode the value of future coupon dollars and principal
repayments; the real interest rate is the return after
deducting inflation. The curve therefore combines anticipated
inflation and real interest rates. Second, the Federal
Reserve directly manipulates only the short-term interest
rate at the very start of the curve. The Fed has three policy
tools, but their biggest hammer is the federal
funds rate, which is only a one-day, overnight rate.
Third, the rest of the curve is determined by supply
and demand
in an auction process.
Sophisticated institutional
buyers have their yield requirements - which, along with their
appetite for government bonds - determine how these
institutional buyers bid for government bonds. Because these
buyers have informed opinions on inflation and interest rates,
many consider the yield curve to be a crystal ball that
already offers the best available prediction of future
interest rates. If you believe that, you also suppose that
only unanticipated events (for example, an unanticipated
increase in inflation) will shift the yield curve up or
down.
Long Rates Tend to Follow Short Rates,
Somewhat
Technically, the Treasury yield curve can
change in various ways: it can move up or down (a parallel
shift), become flatter or steeper (a shift in slope), or
become more or less humped in the middle (a change in
curvature).
The following chart compares the 10-year
Treasury yield (red line) to the one-year Treasury yield
(green line) from Jun 1976 to Dec 2003. The spread between the
two rates (blue line) is a simple measure of steepness:
Consider two observations. First, the two rates
move up and down somewhat together (the correlation for the
period above is about 88%). Therefore, parallel shifts are
common. Second, although long rates directionally follow short
rates, they tend to lag in magnitude. Specifically, when short
rates rise, the spread between 10-year and one-year yields
tends to narrow (curve of the spread flattens) and when short
rates fall, the spread widens (curve becomes steeper). In
particular, the increase in rates from 1977 to 1981 was
accompanied by a flattening and inversion of the curve
(negative spread); the drop in rates from 1990 to 1993 created
a steeper curve in the spread, and the marked drop in rates
from Mar 2000 to the end of 2003 produced a very steep curve
by historical standards.
Supply-Demand
Phenomenon
So what moves the yield curve up or
down? Well, let's admit we can't do justice to the complex
dynamics of capital flows that interact to produce market
interest rates. But we can keep in mind that the Treasury
yield curve reflects the cost of U.S. government debt and is
therefore ultimately a supply-demand phenomenon. (For a
refresher on how increases and decreases in the supply and
demand of credit affect interest rates, see the article Forces Behind Interest Rates.)
Supply-Related Factors
Monetary Policy
If the Fed wants to
increase the Fed Funds rate, it supplies more short-term
securities in open market operations. The increase in
the supply of short-term securities restricts the money
in circulation since borrowers give money to the Fed. In
turn, this decrease in the money supply increases the
short-term interest rate because there is less money in
circulation (credit) available for borrowers. By
increasing the supply of short-term securities, the Fed
is yanking up the very left end of the curve, and the
nearby short-term yields will snap quickly in lockstep.
Can we predict future short-term rates? Well,
the expectations
theory says that long-term rates embed a prediction
of future short-term rates. But consider the actual
December yield curve illustrated above, which is normal
but very steep. The one-year yield is 1.38% and the
two-year yield is 2.06%. If you were going to invest
with a two-year time horizon and if interest rates were
going to hold steady, you would, of course, do much
better to go straight into buying the two-year bond
(which has a much higher yield) instead of buying the
one-year bond and rolling it over into another one-year
bond. Expectations theory, however, says the market is
predicting an increase in the short rate. Therefore at
the end of the year you will be able to rollover into a
more favorable one-year rate and be 'kept whole'
relative to the two-year bond, more or less. In other
words, expectations theory says that a steep yield curve
predicts higher future short-term
rates.
Unfortunately, the pure form of the theory
has not performed well: interest rates often remain flat
during a normal (upward sloping) yield curve. Probably
the best explanation for this is that, because a longer
bond requires you to endure greater interest rate
uncertainty, there is extra yield contained in the
two-year bond. If we look at the yield curve from this
point of view, the two-year yield contains two elements:
a prediction of the future short-term rate plus extra
yield (i.e., a risk premium) for the uncertainty. So we
could say that, while a steeply sloping yield curve
portends an increase in the short-term rate, a gently
upward sloping curve, on the other hand, portends no
change in the short-term rate-the upward slope is due
only to the extra yield awarded for the uncertainty
associated with longer-term bonds.
As Fed
watching is a professional sport, it is not enough to
wait for an actual change in the Fed Funds rate, as only
surprises count. It is important for you, as a bond
investor, to try to stay one step ahead of the rate,
anticipating rather than observing its changes. Market
participants around the globe carefully scrutinize the
wording of each Fed announcement (and the Fed Governors'
speeches) in a vigorous attempt to discern future
intentions. The Fed increasingly tips its hand in
advance. In Aug 2003, for example, the Fed said it would
keep rates low for a considerable period, so the bond
community spent the subsequent months waiting for the
Fed simply to drop this two-word phrase and thereby
signal a future intention to raise the Fed Funds
rate.
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Fiscal
Policy
When the U.S. government runs a deficit,
it borrows money by issuing longer-term Treasury bonds
to institutional lenders. The more the government
borrows, the more supply of debt it issues. At some
point, as the borrowing increases, the U.S. government
must increase the interest rate to induce further
lending. However, foreign lenders will always be happy
to hold bonds in the U.S. government: Treasuries are
highly liquid and the U.S. has never defaulted (it
actually came close to a default in late 1995, but
Robert Rubin, the Treasury Secretary at the time, staved
off the threat and has called a Treasury default
"unthinkable - something akin to nuclear war"). Still,
foreign lenders can easily look to alternatives like Eurobonds,
and therefore they are able to demand a higher interest
rate if the U.S. tries to 'supply' too much of its
debt. |
Demand-Related Factors
Inflation
If we assume that borrowers of
U.S. debt expect a given real return, then an increase
in expected inflation will increase the nominal
interest rate (the nominal yield = real yield +
inflation). Inflation also explains why short-term rates
move more rapidly than long-term rates: when the Fed
raises short-term rates, long-term rates increase to
reflect the expectation of higher future short-term
rates; however, this increase is mitigated by lower
inflation expectations as higher short-term rates also
augur lower inflation (as the Fed sells/supplies more
short-term Treasuries, it collects money and tightens
the money supply):
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An increase in Feds Funds (short-term) tends
to flatten the curve because the yield curve reflects
nominal interest rates: higher nominal = higher real
interest rate + lower inflation.
Fundamental
Economics
The factors that create demand for
Treasuries include economic growth, competitive currencies
and hedging
opportunities. Just remember: anything that increases the
demand for long-term Treasury bonds puts downward pressure
on interest rates (higher demand = higher price = lower
yield or interest rates) and less demand for bonds tends to
put upward pressure on interest rates. A stronger U.S.
economy tends to make corporate (private) debt more
attractive than government debt, decreasing demand for U.S.
debt and raising rates. A weaker economy, on the other hand,
promotes a 'flight to quality', increasing the demand for
Treasuries, which creates lower yields. It is sometimes
assumed that a strong economy will automatically prompt the
Fed to raise short-term rates, but not necessarily. Only
when growth translates or overheats into higher prices is
the Fed likely to raise rates.
In the global economy,
Treasury bonds compete with other nations' debt. On the
global stage, Treasuries represent an investment in both the
U.S. real interest rates and the dollar. The Euro is a
particularly important alternative: for most of 2003, the
European Central Bank pegged its short-term rate at 2%, a
more attractive rate than the Fed Funds' rate of 1%.
Finally, Treasuries play a huge role in the hedging
activities of market participants. In environments of
falling interest rates, many holders of mortgage-backed
securities, for instance, have been hedging their prepayment
risk by purchasing long-term Treasuries. These hedging
purchases can play a big role in demand, helping to keep
rates low, but the concern is that they may contribute to
instability.
Conclusion
We have covered
some of the key traditional factors associated with interest
rate movements. On the supply side, monetary policy determines
how much government debt and money are supplied into the
economy. On the demand side, inflation expectations are the
key factor. However, we have also discussed other important
influences on interest rates, including: fiscal policy (that
is, how much does the government need to borrow?) and other
demand-related factors such as economic growth and competitive
currencies. We've suggested these other factors are constantly
shifting, but two important questions to ask are: Does fiscal
policy create too much supply? and Will the demand for U.S.
denominated debt keep pace in the global market?
Here
is a summary chart of the different factors influencing
interest rates:
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