Factors Infmuencing the Yield Curve Financial Markets, Day 3, Class - PowerPoint PPT Presentation

Factors Infmuencing the Yield Curve Financial Markets, Day 3, Class 2 Jun Pan Shanghai Advanced Institute of Finance (SAIF) Shanghai Jiao Tong University April 20, 2019 Financial Markets, Day 3, Class 2 Factors Infmuencing the Yield Curve Jun Pan 1 / 37

Outline Factors infmuencing the yield curve: economic growth, etc. Statistical analysis of the yield curve: level, slope, and curvature. Financial Markets, Day 3, Class 2 Factors Infmuencing the Yield Curve Jun Pan 2 / 37 ▶ Economic factors: monetary policy, expectations on infmation and ▶ Institutional reasons: next class.

Treasury Yields Financial Markets, Day 3, Class 2 Factors Infmuencing the Yield Curve Jun Pan 3 / 37

Comovement in Yields 90.29 100.0 90.29 46.87 5Y 72.90 82.17 100.0 85.74 57.31 2Y 35.15 40.18 46.87 57.31 94.07 10Y 3M 93.71 Jun Pan Factors Infmuencing the Yield Curve Financial Markets, Day 3, Class 2 Weaker connections between Treasury bills and the rest of the curve. Yields between the nearest maturities are always more correlated. 100.0 85.74 40.18 72.90 35.15 30Y 93.71 100.0 94.07 82.17 100.0 Correlations between daily changes in yields: Correlations between yields (daily data from 1982 to 2015): 96.19 99.18 100.0 98.57 2Y 90.90 93.61 98.57 95.47 100.0 3M 30Y 10Y 5Y 2Y 3M 97.54 5Y 100.0 100.0 99.57 98.19 95.47 90.90 30Y 99.57 99.46 96.19 97.54 93.61 10Y 98.19 99.46 100.0 99.18 4 / 37

The Determinants of the Yield Curve Some often used explanations (not mutually exclusive): Investor’s expectations of future interest rates. Premiums required by investors to hold long-term bonds: risk premium or liquidity preference. Monetary policy: fed funds rate and securities purchasing programs (quantitative easings and operation twist). Expectations of future macroeconomic conditions: economic growth and infmation. Fiscal policy: budget surplus or defjcit. Market segmentation; temporary imbalance of supply and demand; holdings by foreign governments. Financial Markets, Day 3, Class 2 Factors Infmuencing the Yield Curve Jun Pan 5 / 37

Yield Curve, Monetary Policy, and Macroeconomics Financial Markets, Day 3, Class 2 Factors Infmuencing the Yield Curve Jun Pan 6 / 37

Macroeconomics and the Yield Curve There is also evidence linking the slope of the yield curve to future Jun Pan Factors Infmuencing the Yield Curve Financial Markets, Day 3, Class 2 recession. economic slowdown, and an inverted yield curve can be a harbinger of preceded an economic upturn, a fmat yield curve frequently signals an economic conditions: A sharply upward sloping yield curve has often sensitive to infmation concerns. The impact of monetary policy on the short-end of the yield curve is as clear. It is typically believed that the long-term interest rates are The macroeconomic determinants of long-term interest rates are not liquidity of the economy. direct impact on the short-end of the yield curve and the overall or increase). This event, watched by all market participants, has a (FOMC) meets to decide on the fed funds rate (whether to cut, keep, direct. Every six weeks, the Federal Open Market Committee 7 / 37

Fed Funds Rate federal funds rate. Jun Pan Factors Infmuencing the Yield Curve Financial Markets, Day 3, Class 2 economy as a whole. curve (especially the short end), the overall fjnancial markets, and the This aspect of monetary policy has an immediate impact on the yield stance, and in 1995 it began to explicitly state its target level for the Open market operations–purchases and sales of U.S. Treasury and Beginning in 1994, the FOMC began announcing changes in its policy institutions overnight. institutions lend balances at the Federal Reserve to other depository The federal funds rate is the interest rate at which depository implementing monetary policy. federal agency securities–are the Federal Reserve’s principal tool for 8 / 37

Fed Fund Target, Yield Curve, and Business Cycle Financial Markets, Day 3, Class 2 Factors Infmuencing the Yield Curve Jun Pan 9 / 37

Fed Fund Target Rate, Macro Variables, and Yield Curve (e.g., slope) is closely connected with monetary policy. Federal funds Jun Pan Factors Infmuencing the Yield Curve Financial Markets, Day 3, Class 2 and better communications with market participants. Uncertainties in the target rate afgect the markets: Fed transparency futures are also analyzed to extract expectations of future Fed actions. In anticipation of future Fed actions, the shape of the yield curve For the Fed, setting the Fed Funds Target Rate is key to an efgective employment . from a target. Other infmuential macro variables: nonfarm payroll previous four quarters, and y is the percent deviation of real GDP where r is the fed funds rate, p is the rate of infmation over the The Taylor (1993) Rule: monetary policy: price stability and maximum employment. 10 / 37 r = p + 0 . 5 y + 0 . 5 ( p − 2) + 2 ,

GDP, Infmation, and Employment Financial Markets, Day 3, Class 2 Factors Infmuencing the Yield Curve Jun Pan 11 / 37

Quantitative Easing and Operation Twist securities. Jun Pan Factors Infmuencing the Yield Curve Financial Markets, Day 3, Class 2 corp bonds). broad reduction in the cost of credit (e.g., rates on mortgage and In buying Treasury securities, the ultimate goal was to precipitate a Operation Twist: buy longer-term, sell shorter-term Treasury When the short-term interest rates reach to zero, what to do to bring QE3: buy Treasury securities and mortgage-backed securities. QE2: buy Treasury securities. QE1: buy GSE debt, mortgage-backed securities, Treasury securities. tool we would employ. – Ben Bernanke in The Courage to Act. probably the most important and defjnitely the most controversial Our purchases of hundreds of billions of dollars of securities were down longer-term interest rates? 12 / 37

Fed Balance, Securities Held Outright Financial Markets, Day 3, Class 2 Factors Infmuencing the Yield Curve Jun Pan 13 / 37

Fed Balance, Securities by Type Financial Markets, Day 3, Class 2 Factors Infmuencing the Yield Curve Jun Pan 14 / 37

Fed Balance, Treasury Securities by Maturity Financial Markets, Day 3, Class 2 Factors Infmuencing the Yield Curve Jun Pan 15 / 37

Yield Curve and Quantitative Easing Financial Markets, Day 3, Class 2 Factors Infmuencing the Yield Curve Jun Pan 16 / 37

Common Factors in Fixed Income, a Statistical Approach and hence have a negligible efgect on a diversifjed portfolio. Jun Pan Factors Infmuencing the Yield Curve Financial Markets, Day 3, Class 2 the yield curve: level, steepness, and curvature. securities can be explained in terms of three “factors,” or attributes of point out that most of the variation in returns on all fjxed-income In an infmuential article published in 1991, Litterman and Scheinkman securities from the specifjc risk that infmuence securities individually As it is true for fjnancial modeling of any markets, the task of the systematic risks that have a general impact on the returns of most To explain the variation in these returns, it is critical to distinguish bonds and related securities. identifying the common factors that afgect the returns on treasury Market participants have long recognized the importance of the market. fjrst-order importance is to understand the key risk factors afgecting 17 / 37

An Illustrative Example 2 Jun Pan Factors Infmuencing the Yield Curve Financial Markets, Day 3, Class 2 bps, the 2-to-10 spread is 150 bps, and the 2-to-30 spread is 200 bps. Using the 2yr zero as the reference bond, the 2-to-5 spread is 100 28.44 9.52 4.78 1.93 modifjed duration D To simplify our analysis, let’s start with zero-coupon bonds. 10 5 30 maturity zero rate Once we understand the common factors in zero rates of various maturities, we can readily apply this knowledge to coupon bonds, since they are weighted sums of the zero-coupon bond prices. Let’s assume that initially the zero rates (annually compounded) are: 2yr 5yr 10yr 30yr 18 / 37 3.5% 5.5% 4.5% 5% 2 5 10 30 1+3 . 5 % 1+4 . 5 % 1+5 % 1+5 . 5 %

Directional Trade to Bet on a Parallel Shift in Level 5yr Jun Pan Factors Infmuencing the Yield Curve Financial Markets, Day 3, Class 2 -280.22 bps 1 30yr -94.74 bps 1 10yr -47.71 bps The yield on the 2yr zero subsequently increases by 10 bps. All spreads 1 19 / 37 -19.30 bps initial later market value ($ million) change notional approximation remain the same. 2yr ($ million) 1 (1+3 . 5 % ) 2 (1 + 3 . 5 % ) 2 -1.93 × 10 bps (1+3 . 5 % +10 bps ) 2 (1+4 . 5 % ) 5 (1 + 4 . 5 % ) 5 -4.78 × 10 bps (1+4 . 5 % +10 bps ) 5 (1+5 . 0 % ) 10 (1 + 5 . 0 % ) 10 -9.52 × 10 bps (1+5 . 0 % +10 bps ) 10 (1+5 . 5 % ) 30 (1 + 5 . 5 % ) 30 -28.44 × 10 bps (1+5 . 5 % +10 bps ) 30

Steepener 2yr Jun Pan Factors Infmuencing the Yield Curve Financial Markets, Day 3, Class 2 Why 4.9286? Because 4.9286=9.52/1.93 is the ratio of the modifjed 10yr Your view: the 2-to-10 spread will increase but not sure of the overall 20 / 37 ($ million) ($ million) notional amount initial market value Long $4.9286M of 2yr zero and short $1M of 10yr zero: Your strategy: steepener. direction of the interest rate. 4 . 9286 × (1 + 3 . 5 % ) 2 4 . 9286 − (1 + 5 . 0 % ) 10 − 1 duration D ∗ of a 10yr zero over that of a 2yr zero.