A major topic of interest of this blog is interest rate formation – what are the factor(s) that determine bond yields over time? In other words, how can we model the squiggly line in the chart below? Note that throughout this article, I am referring only to (central) government bonds that are issued in the local currency. For example, pricing a corporate bond needs to incorporate a premium to cover the risk of default. (NOTE: this article is an introduction to this the subject; see this "Theme" post to see further discussion of this subject.)
My response, which I believe is non-controversial amongst most bond market practitioners, is that interest rate expectations are the primary explanation for the level of yields. (The preferred formulation of a portfolio manager I worked with was “interest rate expectations with technical factors”). In fact, this view is so non-controversial I would guess that many will have stopped reading already (“Well, duh! Time to go back to reading TOP on Bloomberg.”). For those of you who have continued reading, I want to cover some of the less obvious implications of this viewpoint.
One simple formulation of the interest rate expectations model is: the yield on a (credit risk free) bond should equal the expected cost of financing the bond at a short-term rate over the bond's lifetime.
This essentially is a statement that the bond market is efficient. The initial yield to maturity of a bond represents the breakeven point of the strategy of buying the bond with 100% leverage and holding it to maturity. If we take a 10-year bond* as an example, the implication is that the yield should equal the expected (geometric) average of the 1-day financing rate over the next 10 years**.
One should also slap a risk premium into the bond yield, but the assumption here is that this risk premium should be small and stable; for example running around 25-50 basis points or so.
In the U.S. Treasury market, the cost of financing a bond overnight (the overnight repo rate) is typically close to the Fed Funds rate, which is supposed to be near the Fed Funds Target Rate set by the Fed. There can be spreads in those funding costs, but they are of the magnitude of dozens of basis points, which is a small residual relative to the volatility in the pricing of most Treasurys with maturities two years and up. Therefore, it is not an accident that there appears to be some sort of relationship between the “market-determined” 10-year yield and the “administered” overnight rate (Fed Funds Target in the U.S.).
What I find interesting about this point of view are the things that do not directly determine the level of bond yields. Examples:
· pretty well every fiscal variable (deficits, debt/GDP ratios, whatever);
· what big investors (e.g. Chinese reserve managers) are doing;
· the size of the central bank’s balance sheet (QE!);
· inflation (but see note below);
· expected returns for other, lesser, asset classes like equities;
· the level of real rates versus some benchmark level such as an historical average or zero;
· bond yields in other currencies;
· how the currency is trading.
What may be a surprising theme is that supply and demand don’t matter (e.g. deficits or investor positioning), rather the assumption is that markets are efficient discounting mechanisms for expected returns***. Unusually, “free market oriented” economists, who are typically associated with holding a “markets are efficient” view can quite often write commentary implying the opposite – that fiscal variables can have a major impact on the bond yields (for example).
However, the unanswered question is: what determines the expectations for the short-term rate? In the absence of reliable crystal balls, market participants are stuck with attempting to model the central bank’s reaction function. Thus, inflation is only an indirect input to the “model” for bond yields - it only matters if the central bank reacts to it. Of course, since most relevant central banks practice inflation targeting, it should be a relatively important input, but as I will discuss in future posts, observed inflation has not been very relevant in practice for the last 20 years or so.
* In the U.S. market, Treasurys with 10-year maturities at issue are officially referred to as “Treasury Notes”, only longer maturities like the 30-year are “Treasury Bonds”. However, I used the generic “10-year bond” (lowercase) for simplicity.
** You need to correct for the various archaic yield conventions used in the bond and money markets if you want to get all fussy about the calculations.
***Supply and demand represent the “technical factors” alluded to in the quote by the portfolio manager above. I feel that these factors are mainly visible in maturities beyond the 10-year point, e.g., 30-year bonds. Even so, the magnitude of these factors are generally quite small, other than for some extremely distorted markets like the gilt market after various pension reforms in the 1990s.
(c) Brian Romanchuk 2013