FNCE 4070 Financial Markets and Institutions

1
FNCE 4070Financial Marketsand Institutions

• Lecture 5 Part 2
• Forecasting With the Term Structure of Interest
  Rates
• (1) Forecasting Business Cycle Turning Points (A
  Recession)
• (2) Forecasting Future Interest Rates
  (Estimating Forward Rates)
• (3) Estimating Future Rates of Inflation (Using
  TIPS)

2
Downward Sweeping or Inverted Yield Curve And
Economic Activity

• Inverted Yield Curve

• Discussion

• Inverted Yield Curve An interest rate
  environment in which long-term debt
  instruments have a lower yield than short-term
  debt instruments of the same credit quality.
• This type of yield curve is the rarest of the
  three main curve types and is considered by some
  to be a predictor of an economic recession (i.e.,
  business cycle turning point).
• Why An inverted yield curve signals a future
  fall in interest rates which is consistent with a
  recession.

3
Interest Rates and Business Cycles 1969 1983
4
Interest Rate Spreads and Business Cycles 1969 -
1983
5
Interest Rates and Business Cycles 1987 2011
6
Interest Rate Spreads and Business Cycles 1987 -
2011
7
Evidence from Australia
8
Evidence From the U.K.
9
Yield Curves and Recessions The Evidence

• Since the late 1980s, many researchers have
  provided evidence that the yield curve, or
  specifically the spread between long term and
  short term interest rates, has been a predictive
  signal of future recessions. They include
• Arturo Estralla and Fredric Mishkin (June 1996),
  The Yield Curve as a Predictor of U.S.
  Recession (http//www.newyorkfed.org/research/cur
  rent_issues/ci2-7.pdf), found that the yield
  curve outperformed other financial and economic
  indicators in predicting recessions, especially 2
  to 3 quarters into the future.
• Arturo Estrella and Mary R. Trubin July/August
  2006 The Yield Curve as a Leading Indicator
  Some Practical Issues http//www.newyorkfed.org/r
  esearch/current_issues/ci12-5.pdf. Analyzed the
  yield spreads for six recessions from 1970 to
  2001.
• Glenn D. Rudebusch and John C. Williams (July
  2008), Forecasting Recessions The Puzzle of the
  Enduring Power of the Yield Curve, found that a
  simple model for predicting recessions that uses
  only real-time yield curve information would have
  produced better forecasts of recessions than
  professional forecasters

10
Using Probit Analysis to Test the Probability of
a Recession (Estrella and Trubin)
11
Using Probit Analysis to Test the Predictive
Value of the Yield Curve (Estralla and Mishkin)
12
The Yield Curve and Interest Rate Forecasting

• Two of the yield curve theories are especially
  relevant for forecasting future interest rates.
  They are
• Pure Expectations Theory
• Which assumes no liquidity premium for longer
  term debt instruments.
• Liquidity Preference Theory
• Which incorporates a liquidity premium for longer
  term debt instruments.
• Both of these theories involves the role of
  forward rates in setting spot rates.
• Thus we can arrange their formulas to calculate
  implied forward rates for any future period of
  time.

13
Forecasting with The Expectations Theory

• Recall that the Expectations Theory assumes that
  the current long term spot interest rate is
  comprised of
• Current (spot) short term interest rate (iss) and
  
• Expected, future (forward) short-term interest
  rates (ie).
• If we assume the long term spot rate (ils) is an
  average of short term rates (iss and ie), it is
  possible to derive the expected forward rate
  (ie), on a one-period bond for some future time
  period (n-t) through the following formula

14
Forecasting With The Expectations Model Example
1

• Assume the following
• Current 1 year spot (iss1) 5.0
• Current 2 year spot (ils2) 5.5
• Use the formula on the previous slide to
  calculate the implied forward rate, or the 1year
  rate, 1 year from now

15
Yield Curve For Example 1

• Yield Curve

• The Forward Rate

• The calculated forward rate of 6.00 is the
  markets expected 1 year interest rate one year
  from now.
• This rate of 6.00 becomes our forecasted
  interest rate using the pure expectations model.

• interest rate
• 6.0 oie
• 5.5 oils2
• 5.0 oiss1
• 1y 2y
• Term to Maturity

16
Forecasting With The Expectations Model Example
2

• Assume the following
• Current 1 year spot (iss1) 7.0
• Current 2 year spot (ils2) 5.0
• Use the formula on the previous slide to
  calculate the implied forward rate, or the 1year
  rate, 1 year from now

17
Yield Curve For Example 2

• Yield Curve

• The Forward Rate

• The calculated forward rate of 3.04 is the
  markets expected 1 year interest rate one year
  from now.
• This rate of 3.04 becomes our forecasted
  interest rate using the pure expectations model.

• interest rate
• 7.0 oiss1
• 5.0 oils2
• 3.0 oie
• 1y 2y
• Term to Maturity

18
Using the Current Yield Curve Data to Forecast
Interest Rates

• Bloomberg Data U.S. Treasuries, Feb 24, 2011

• Expectations Model

• What is the yield curve telling us about the
  markets expectation regarding future interest
  rates
• Going up or going down? Can you approximate some
  forward rates?
• 3 month rate, 3 months from now?
• 1 year rate, 1 year from now?

COUPON MATURITY PRICE/YIELD
3-Month 0.000 05/26/2011 0.11 / 0.12
6-Month 0.000 08/25/2011 0.15 / 0.15
12-Month 0.000 02/09/2012 0.23 / 0.23
2-Year 0.625 02/28/2013 99-28 / 0.73
3-Year 1.250 02/15/2014 100-02 / 1.22
5-Year 2.125 02/29/2016 99-11 / 2.18
7-Year 2.625 01/31/2018 98-20 / 2.84
10-Year 3.625 02/15/2021 101-17 / 3.44
30-Year 4.750 02/15/2041 103-17½ / 4.53
19
Forecasting with the Liquidity Premium Theory

• Recall that the liquidity premium theory modifies
  the expectations theory formula to take into
  account liquidity premiums (Ln), or
• Where, Ln is the liquidity premium for holding a
  bond of n maturity.
• Furthermore, Ln will always be positive.
• Given the addition of a liquidity premium an
  observed yield curve will always have an upward
  bias.
• So even if forward interest rates are expected to
  stay the same, the yield curve will slope upward.

20
Predictions ofFuture Interest Rate Moves with
the LP ModelNote Solid yield curve is
observed and broken line is taking out positive
LP. (a) Implied increase in forward rate
greater than LP.(b) Implied increase in
forward rate equal to LP .(c) Implied decrease
in forward rate slightly greater than LP.(d)
Implied decrease in forward rate much greater
than LP.
21
Forecasting Forward Rates with the Liquidity
Premium Theory

• The liquidity premium theory formula for
  calculating forward rates is as follows
• Therefore, in order to forecast an actual forward
  rate we need some estimate as to the liquidity
  premium (Ln), which insert into the above
  formula.

22
Estimating the Liquidity Premium (Ln)

• U.S. Government Securities
• 1993 2007 data
• Mean Returns
• 3 month 3.96
• 6 month 4.13
• 1 year 4.28
• 2 year 4.60
• 5 year 5.07
• 10 year 5.42
• 20 year 5.92

• Liquidity Spreads (in basis points)
• 3 months -----
• 6 months 17
• 1 year 32
• 2 year 64
• 5 year 111
• 10 year 146
• 20 year 196

23
Forecasting with the Liquidity Premium Theory
Example 1

• Assume the following
• Current 1 year spot (iss1) 5.0
• Current 2 year spot (ils2) 5.5
• Liquidity premium (Ln) for 2 year debt 32 basis
  points (64-32).
• Use the liquidity premium formula to calculate
  the implied forward rate, or the 1year rate, 1
  year from now

24
Forecasting with the Liquidity Premium Theory
Example 2

• Assume the following
• Current 1 year spot (iss1) 7.0
• Current 2 year spot (ils2) 5.0
• Liquidity premium (Ln) for 2 year debt 32 basis
  points (64-32).
• Use the liquidity premium formula to calculate
  the implied forward rate, or the 1year rate, 1
  year from now

25
Comparing Expectations and Liquidity Premium
Forecasts

• Example 1

• Example 2

• 1 year rate 7.0
• 2 year rate 5.0
• Expectations Forecast 3.04
• Liquidity Premium Forecast 2.41
• Note Expectations model understated forecast for
  falling interest rates.

• 1 year rate 5.0
• 2 year rate 5.5
• Expectations Forecast 6.0
• Liquidity Premium Forecast 5.36
• Note Expectations model overstated forecast for
  rising interest rates.

26
An Actual Interest Rate Forecast

• Using interest rate data from March 9, 2011
  Bloomberg site as follows
•  
• 1 year T-Bills 0.24
• 2 year T-Bills 0.69
•  
• And assuming liquidity premium of 32 basis points
  for 2 year Treasury debt (see slide 22).
•   
• Using the liquidity premium forecasting model,
  calculate the 1 year rate, 1 year from now
•  
•  

27
Market Segmentations Theory

• Observation Near the end of a business expansion
  (period before shaded areas) short term interest
  rates (blue line) exceed long term interest
  rates.
• Thus, during this period we would observe a
  downward sloping yield curve.

28
Market Segmentations Theory Explaining the Yield
Curve Near the End of a Business Expansion

• Why is there an inverted yield curve at this
  time?
• Interest rates have risen during the expansionary
  period and are now relatively high.
• Borrowers realizing that rates are relatively
  high, finance in the short term (not wanting to
  lock in long term liabilities at high interest
  rates).
• Lenders realizing that rates are relatively high,
  lend in the long term (wanting to lock in long
  term assets at high interest rates)
• Note Both borrowers and lenders move away from
  their natural tendencies.

29
Market Segmentations Yield Curve Near the End of
an Expansion

• i rate
• o Lenders supplying
  longer
• term funds (pushes down
  rates)
• Borrowers demanding shorter
  o
• term funds (pushes up rates)
• (st) Term to Maturity (lt)

30
Forecasting with the Market Segmentations Theory

• The Market Segmentations Theory CANNOT be used to
  forecast future spot rate (forward rates).
• The Market Segmentations Theory can be used to
  identify (signal) turning points in the movement
  of interest rates (and in the economy itself)
  based on the shape of the curve.
• Downward sweeping curve suggests a fall in
  interest rates, the end of an economic expansion,
  and a future economic (business) recession.
• Severe upward sweeping curve suggests a rise in
  interest rates, the end of an economic recession,
  and a future economic (business) expansion.

31
Summary of Yield Curves and Business Cycles
32
Estimating Future Rates of Inflation

• Using the TIPS market to determine the
  breakeven inflation rate.
• Assumption
• Conventional Treasury rate includes both real
  rate and inflation premium.
• TIPS rate is simply the real rate.
• Breakeven inflation rate Yield to maturity on
  conventional Treasuries Yield to maturity on
  TIPS.
• Important Use similar maturities.
• Difference is the markets annual inflation
  expectation over the maturity period.

33
U.S. Treasury Yield Curve Site for Observing
Breakeven Rate of Inflation

• Link to the U.S. Treasury site below for the
  nominal and TIPS yield curve.
• http//www.treasury.gov/resource-center/data-chart
  -center/interest-rates/Pages/Historic-Yield-Data-V
  isualization.aspx
• From this site, one can observe the breakeven
  inflation rate.
• What is the most recent data telling you about
  the markets expectation regarding inflation?
• Set the date for January 2, 2009 and observe the
  breakeven rate.
• What is this date telling you about the markets
  expectation regarding inflation?
• From this site, one can also download the actual
  data.
• Note The most recent 5-year TIPS yield curve
  data point is incorrect (however, the actual data
  is correct).
• According to the Treasury Department, the
  graphing function is flawed.

34
Appendix 1

• Why Do Markets Care about Yield Curves?
• The following is from Bonds on Line and
  summarizes why yield curves are important.
  http//www.bondsonline.com/Corporate_Bond_Yield_In
  dex.phpwhy

35
Using Yield Curves

• The shape of the yield curve is closely followed
  by bond investors.  It provides information about
  the yields of short term compared to long term
  fixed-income investments.  Investors analyze and
  interpret the yield curve shape to give some
  insights on the future direction of rates and the
  economy.   
• A yield curve normally has an upward sloping
  shape. That is, in a normal yield curve,
  shorter-term yields are lower than longer-term
  yields, with yields generally increasing as years
  to maturity increase.  The yields are higher on
  securities with longer maturities because these
  securities are more vulnerable to price changes
  caused by changes in interest rates over time. 
  Investors in longer-term securities are typically
  rewarded with a higher yield for taking the risk
  that interest rates could rise and cause the
  prices of their securities to fall. 
• Investors pay attention to both the current shape
  of the yield curve, whether it is steep or flat,
  and yield curve movements.  That is, investors
  will look at whether the entire curve is shifting
  up or down in a parallel fashion which suggests
  that rates across the maturity spectrum are
  changing by the same magnitude or, alternatively,
  the shape or slope of the curve is becoming
  flatter or steeper.  For example, when Federal
  Reserve monetary policy is more accommodative and
  reduces short term rates, the yield curve
  generally steepens, and flattens when monetary
  policy tightens the Fed raises short term rates.

36
Using Yield Curves

• When the yield curve is steep, that is when the
  difference between short-term and long-term
  yields is large, the market often expects
  interest rates to rise, though there are a number
  of variables, including the rate of economic
  growth and inflationary expectations, that go
  into interest rate analysis and forecasting the
  risk at the long end of the maturity range is
  therefore greater, and so is the return or
  yield.  When the yield curve is relatively flat,
  the difference between short-term yields and
  long-term yields is not that great.  When this
  happens, the market is not rewarding investors
  for taking the risk of a longer maturity,
  possibly because the market believes interest
  rates will decline, causing bond prices to rise
  and yields to fall.  Investors holding securities
  with longer maturities tend to benefit more from
  a declining interest rate trend. 
• There have been brief and unusual periods of time
  when the there has been what is known as an
  inverted yield curve shape, where, at certain
  points along the maturity spectrum, short-term
  yields have been higher than long-term yields.
  Inversely sloped yield curves are not sustainable
  either short term yields will eventually fall
  or long term yields rise. An inverted yield curve
  is considered an omen of recession as well as
  lower interest rates.

37
Appendix 2

• Ben Bernanke and the 2006 Yield Curve.
• Shortly after Bernanke became Chair of the Fed
  (Feb 1, 2006) he spoke before the Economic Club
  of New York.  The presentation to that group was
  given on March 20, 2006.  The yield curve which
  had been upward sweeping in 2004 (and thus
  normal) began to flatten in 2005 through 2006 and
  was approaching almost flat by the time Bernanke
  spoke.  The following is a direct quote from
  Bernankes presentation regarding the flattening
  yield curve in 2006.

38
Ben Bernanke Discusses the 2006 Yield Curve

• Although macroeconomic forecasting is fraught
  with hazards, I would not interpret the currently
  very flat yield curve as indicating a significant
  economic slowdown to come, for several reasons.
  First, in previous episodes when an inverted
  yield curve was followed by recession, the level
  of interest rates was quite high, consistent with
  considerable financial restraint. This time, both
  short- and long-term interest rates--in nominal
  and real terms--are relatively low by historical
  standards. Second, as I have already discussed,
  to the extent that the flattening or inversion of
  the yield curve is the result of a smaller
  liquidity term premium, the implications for
  future economic activity are positive rather than
  negative. Finally, the yield curve is only one of
  the financial indicators that researchers have
  found useful in predicting swings in economic
  activity. Other indicators that have had
  empirical success in the past, including
  corporate risk spreads, would seem to be
  consistent with continuing solid economic growth.
  In that regard, the fact that actual and implied
  volatilities of most financial prices remain
  subdued suggests that market participants do not
  harbor significant reservations about the
  economic outlook.
•  

39
Appendix 3

• Central Bankers
• Bank of England
• ECB
• Bank of Japan
• Federal Reserve

40
Mervyn Allister KingGovernor, Bank of England

• Mervyn King is Governor of the Bank of England
  and is Chairman of the Monetary Policy Committee.
  He was previously Deputy Governor from 1998 to
  2003, and Chief Economist and Executive Director
  from 1991. Mervyn King was a non-executive
  director of the Bank from 1990 to 1991.
• Born in 1948, Mervyn King studied at Kings
  College, Cambridge, and Harvard (as a Kennedy
  Scholar) and taught at Cambridge and Birmingham
  Universities before spells as Visiting Professor
  at both Harvard University and MIT. From October
  1984 he was Professor of Economics at the London
  School of Economics where he founded the
  Financial Markets Group.
• Mervyn King is a Fellow of the British Academy,
  an Honorary Fellow of Kings and St Johns
  Colleges, Cambridge and holds honorary degrees
  from Birmingham, City of London, Edinburgh,
  London Guildhall, London School of Economics,
  Wolverhampton, Cambridge and Helsinki
  Universities. He is a Foreign Honorary Member of
  the American Academy of Arts and Sciences, is on
  the Advisory Council of the London Symphony
  Orchestra, is Patron of Worcestershire County
  Cricket Club and is a Trustee of the National
  Gallery.

41
Jean-Claude TrichetPresident, ECB

• Jean-Claude Trichet was born December 20, 1942 in
  Lyon, France. A graduate of the University of
  Paris in Economics, Trichet also holds degrees in
  mining engineering and worked in the private
  sector before joining the French civil service.
• In the early 1970s, Trichet was named the General
  Inspectorate of Finance, eventually becoming the
  Director of the Treasury Department in 1987. In
  1993, Trichet accepted the position of Governor
  of the Banque de France and was reappointed to
  the same position in 1999.
• After serving as a member of the Council of the
  European Monetary Institute, Trichet was named to
  the Governing Council of the European Central
  Bank in 1998. On November 1, 2003, Jean-Claude
  Trichet was named President of the European
  Central Bank.

42
Masaaki ShirakawaGovernor, Bank of Japan

• Governor Masaaki Shirakawa became the 30th
  Governor of the Bank of Japan in April 2008. He
  joined the Bank in 1972, after graduating from
  the University of Tokyo with a B.A. degree in
  Economics. He also received an M.A. in Economics
  from the University of Chicago.
• Mr. Shirakawa assumed jobs with increasing
  responsibility throughout his career. He has held
  a number of senior positions. In 1990-1993, he
  served as Director, Head of Financial System
  Division at the Financial and Payment System
  Office. In 1993-1994, he headed the Planning
  Division of the Policy Planning Office. In
  1994-1996 he served as General Manager for Oita
  Branch and General Manager for the Americas.
• In 1996-1997, Mr. Shirakawa was Deputy
  Director-General of the Institute for Monetary
  and Economic Studies and of the International
  Department. Since 1997, he served as Adviser to
  the Governor at Credit and Market Management
  Department, Financial Markets Department and
  Policy Planning Office. He was appointed
  Executive Director in 2002.
• In addition to his policy work with the Bank of
  Japan, Mr. Shirakawa worked in academia, as
  Professor at the Kyoto University School of
  Government in 2006-2008.

43
Ben S. Bernanke,Governor, Federal Reserve

• Ben S. Bernanke began a second term as Chairman
  of the Board of Governors of the Federal Reserve
  System on February 1, 2010. Dr. Bernanke also
  serves as Chairman of the Federal Open Market
  Committee, the System's principal monetary
  policymaking body. He originally took office as
  Chairman on February 1, 2006, when he also began
  a 14-year term as a member of the Board. His
  second term as Chairman ends January 31, 2014,
  and his term as a Board member ends January 31,
  2020.
• Before his appointment as Chairman, Dr. Bernanke
  was Chairman of the President's Council of
  Economic Advisers, from June 2005 to January
  2006.
• From 1994 to 1996, Dr. Bernanke was the Class of
  1926 Professor of Economics and Public Affairs at
  Princeton University. He was the Howard Harrison
  and Gabrielle Snyder Beck Professor of Economics
  and Public Affairs and Chair of the Economics
  Department at the university from 1996 to 2002.
  Dr. Bernanke had been a Professor of Economics
  and Public Affairs at Princeton since 1985.
• Before arriving at Princeton, Dr. Bernanke was an
  Associate Professor of Economics (1983-85) and an
  Assistant Professor of Economics (1979-83) at the
  Graduate School of Business at Stanford
  University. His teaching career also included
  serving as a Visiting Professor of Economics at
  New York University (1993) and at the
  Massachusetts Institute of Technology (1989-90).
• Dr. Bernanke has published many articles on a
  wide variety of economic issues, including
  monetary policy and macroeconomics, and he is the
  author of several scholarly books and two
  textbooks. He has held a Guggenheim Fellowship
  and a Sloan Fellowship, and he is a Fellow of the
  Econometric Society and of the American Academy
  of Arts and Sciences. Dr. Bernanke served as the
  Director of the Monetary Economics Program of the
  National Bureau of Economic Research (NBER) and
  as a member of the NBER's Business Cycle Dating
  Committee. In July 2001, he was appointed Editor
  of the American Economic Review. Dr. Bernanke's
  work with civic and professional groups includes
  having served two terms as a member of the
  Montgomery Township (N.J.) Board of Education.
• Dr. Bernanke was born in December 1953 in
  Augusta, Georgia, and grew up in Dillon, South
  Carolina. He received a B.A. in economics in 1975
  from Harvard University (summa cum laude) and a
  Ph.D. in economics in 1979 from the Massachusetts
  Institute of Technology.