Lecture Materials TOPIC 3: YIELD CURVES AND INTEREST FORECASTS ECONOMICS, MONEY MARKETS AND BANKING James M. Johannes Interim Associate Dean for Executive and Evening MBA Programs Aschenbrener Chair of Banking & Finance Graduate School of Banking-Prochnow Professor of Banking Director, Puelicher Center for Banking Education Director, Officer Education Program University of Wisconsin-Madison Madison, Wisconsin jjohannes@bus.wisc.edu 608-265-2323 August 2-5, 2016
Topic 3 Yield Curves and Interest Forecasts
I. Yield Curve (Term Structure of Interest Rates) Basics 1. What is the Yield Curve? Interest rates on financial instruments vary because of default risk, liquidity risk, call provisions, etc. Holding all the above constant, it also appears rates vary because of maturity. The relationship between interest rates and maturity, all else fixed, is called the term structure of interest rates or the yield curve. Where do we find the yield curve? Typical yield curve. 2
Yield Curves are Important so Found Everywhere 3
Note: downward sloping when rates high Flatter when rates moderate Upward sloping when rates low 4
II. Determinants of the Yield Curve Shape A. Segmented Markets View: independent markets i S i S.10 D Short-term funds D Long-term funds Players: Fed Banks Insurance/pension companies Instruments: T-bills, commercial paper Mortgages, bonds, note 5
Implied Yield Curve i.12.10 1 30 maturity Operation Twist (early 1960 s) To raise short rates and lower long rates Fed was to sell bills and buy bonds. 6
Implied Yield Curve i Fed sold T-bills from its portfolio. This should lower T-bill prices and raise short term rates..12.10.08 Fed then purchased long term Treasury Securities, trying to drive long term debt prices up, and long rates down. 1 30 maturity Operation Twist (early 1960 s) To raise short rates and lower long rates Fed was to sell bills and buy bonds. 7
Observation 1: Twist does not change money in circulation-if the Fed sells one thing and buys another the money * stays the same! *technically, the monetary base, more on this friday 8
Point 2: Operation Twist no help for bankers! Government Yield Curve 10 9 8 7 Interest Rate 6 5 4 3 Original spread 4% New spread 1% 2 1 0 1 2 3 4 5 6 7 8 Maturity (years) 9
Good point to bring up the many different dimensions of monetary policy Pure Monetary policy is usually viewed as something that affects the money supply, monetary base or bank reserves or maybe basic interest rate levels. Credit Policy (like a pure twist operation) can be neutral as far as the money supply goes but can also be a credit policy that is not neutral in outcome. For example, suppose the Fed twists by selling Treasury securities and buying Mortgage backed securities. Money supply stays the same but the Fed provides credit directly and specifically to the housing sector. Credit policy is not monetary policy because it does not increase bank reserves or the monetary base. Fiscal policy ( government spending ): Fed lending $ it earned off investing bank reserves in treasury securities ($ it could have given back to the Treasury)to JPMorgan to purchase Bear Stearns or the $50 billion dollars the Fed loaned its subsidiaries Maiden Lane II and III to purchase, residential mortgage-backed securities from AIG, and multi-sector collateralized debt obligations on which AIG has written credit default swap contracts to keep AIG afloat. 10
B.Pure Expectations View (sometimes called the Rational Expectations View) 1. Example: Suppose an investor has a two-year time horizon (holding period). Suppose further that 1- year and 2-year deposits exist. Suppose further that the current 1-year rates is 4% and the depositor thinks the 1-year rate one year from now will be 10%. What rate would you have to offer to get this depositor to put money in a 2-year deposit. What does the depositor expect to make on two 1- year deposits? (Let s ignore compounding). First year return + expected second year return.04 +.10 =.14 = 14% 11
What would seller of 2-year deposit have to offer to attract a buyer? R 2 + R 2 =.14 2 R 2 =.14 R 2 =.07 = 7% 12
2. Implications for Yield Curve i Example shows that the 2-year rate will end up being roughly the average of the current 1-year rate and the expected 1-year rate, i.e.,.04 +.10.07* = This implies that the yield curve is drawn for some market expectation of short-term rates in the future. Yield curve given the.07 Market thinks the 1-year.04 10% 1 2 maturity 2 rate next year is going to be * What if This Doesn t Hold? a) If R 2 < 7, nobody will buy 2yr Bonds. Price will fall, rate will increase b) If R 2 > 7, everybody will buy 2yr Bonds. Price will Rise, rate will fall 13
This implies that the expected future direction of rates is embedded in the yield curve. To see this, what if the market thinks the 1-year rate next year will be 4% or 20%? I.12 If 1-year rate next year expected to be 20%.07 If 1-year rate next year expected to be 10%.04 If 1-year rate next year expected to be 4%.03 If 1-year rate next year expected to be 2% 1 2 maturity R2 R2 R2 R2 = = =.04 +.20 2.04 +.10 2.04 +.04 2.04 +.02 = 2 14
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Conclusion (compare to picture of typical yield curve) Yield Curve Slope Flat Upward Downward Markets Guess of Where Rates are Headed No change in rates Rates will rise Rates will fall 16
Formal yield curve forecasts Let R i = current known rate from the WSJ on i period Investments Then, t F i = forward rates = markets guess of rate on i period investments, t periods from now 2R 2 = R 1 + 1 F 1 (invest in a 2 yr, or two 1 yrs) 3R 3 = R 1 + 2 1 F 2 (invest in a 3 yr, or a one and a two) 3R 3 = 2R 2 + 2 F 1 (invest in a 3 yr, or a two and a one) Solutions R R R 2 3 3 = = = R R 1 1 2R 2 + 1F1 2 + 21F 3 + 2F1 3 2 17
Example Yield Curve on June 2, 2016 R 1 =.0068 R 2 =.0089 R 3 =.0103 What does the market think the 1-year rate will be in 2017? 2 R 2 = R 1 + 1 F 1 1F 1 = 2 R 2 - R 1 = 2(.0089) -.0068 =.011 Last year 1 F 1 =.011 so it overestimated What does the market think the 1-year rate will be in Aug 2018? 3R 3 = 2R 2 + 2 F 1 2F 1 = 3(.0103) - 2(.0089) =.0131 18
One year Implied Forward Graph found in Monetary trends Forward rates- numbers differ a little from pure forward because they interpolate and smooth 19
Four Applications of this Theory 1. Riding the yield curve 2. Loan interest swaps 3. QE s and Twist 4. Forecasting rates 20
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III. Yield Yield Curve Games A. Riding the Yield Curve for Fun and Profit Basic idea: Assuming a positively sloped yield curve, purchase a security with a maturity longer than your expected holding period. Rationale: You will make money because 1) longer maturities pay higher rates, 2) when you sell it in the security will have a shorter maturity, hence lower rates, hence a capital gain..07.04 1 2 maturity (years) 22
Example: You want to invest for 1 year. Current 1-year rate is 4%, 2-year rate is 7%. -- If you buy 1-year security make 4% -- If ride, price per dollar of face of 2-year security is.8734. If sell in one year when 1-year rate is 4%, get.9615.9615.8734 Profit = =.1009 =.8734 2 Price * (1.07) Price = 1.00 2 (1.07) = 1.00 =.8734 Price* (1.04) = 1.00 Price = 1.00 (1.04) = 10.1%.9615 23
Will this work in an efficient market? -- What will you be able to sell the security at next year? The market expects the rate on 1- year securities to be 10%. This implies the price will be.9090..9090.8734 Profit = =.040 =.8734 4% NOTE: You will make money riding the yield curve as long as the 1-year rate next year turns out to be less than the market forecast. If the rate turns out to be more than the market forecast, you will lose money. The market forecast is a breakeven rate. 24
What if 1 year rate next year ends up 14%!.8772.8734 Profit = 0!.8734 25
Forward Rate - Actual Rate 4.0% 3.0% If positive, market overestimated what rates would be, i.e. rate ended up less than the market expected. 2.0% 1.0% 0.0% 06/1976 06/1978 06/1980 06/1982 06/1984 06/1986 06/1988 06/1990 06/1992 06/1994 06/1996 06/1998 06/2000 06/2002-1.0% -2.0% -3.0% Article recom -mands riding! Rates went up more than the market thought! i.e got burned is you rode (markets underestimated inflation) -4.0% Forwards over estimate, in part, because the risk premium is not netted out of the long rate before the calculation is done. 26
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LIBOR SWAPS Suppose the banker wants to receive variable rate interest, but the customer wants to pay fixed. Impasse! No Deal? Solution: Let the customer pay fixed, then swap the fixed for Libor (variable) in the interest swap market. The curve on the next page says the market will trade about 4.13% fixed each year for two years in exchange for 3 month Libor each quarter for two years. 28
So let s use a somewhat far fetched example to show the principle. The customer pays fixed 7% and our bank SWAPs it out by paying 4.13% to get whatever Libor turns out to be. 29
CURRENT RATES DOWN RATES UPRATES UP 1% 2% 4% LOAN RATE 7% 7% 7% 7% CD RATE (LIBOR) -4% - 3% - 6% - 8% Internal Spread 3% 4% 1% -1% (LOAN RATE-CD RATE) SWAP SIDE Pay Fixed 4.13% 4.13% 4.13% 4.13% Get Libor 4% 3% 6% 8% Net on SWAP -.13% -1.13% +1.87% +3.87% $ IN Loan Rate 7% 7% 7% 7% Get Libor in SWAP Mkt 4% 3% 6% 8% $OUT CD Rate to Customer 4% 3% 6% 8% Fixed to SWAP Mkt 4.13% 4.13% 4.13% 4.13% Interest to Bank 2.87% 2.87% 2.87% 2.87% 30
How does the market come up with this tradeoff? (Let s use annual Libor for simplicity) R1 + = 2 Libor now 4% + 1F1 Libor next year 10% = 2R The fixed rate for two years 2(7%) Then market will add a risk premium in case customer defaults. 31
Real World Suppose a customer knows that the market typically overestimates short-term rates. In our example, suppose customer thinks rate next year on 1 year stuff is going to be 8%, not 10%. Then, they will prefer the variable to the fixed, because 4% + 8% < 7% + 7%. 32
Quantitative Easing: How Did the Fed Get Away with Lowering Long-term rates? Huge shift in fed portfolio away from Treasury Securities 33
Total Assets held by the Federal Reserve $ tillions $4 QE1 QE2 QE3 $3 $2 $1 $0 2006 2007 2008 2009 2010 2011 2012 2013 2014 34
QE1 Bailout Phase QE1 is a nickname developed to refer to the first round of quantitative easing in November 2008. Purchase GSE debt of $100 billion and MBS of $500 billion (then increased to $200 billion and $1.25 trillion in 2009 plus $300 billion in long term treasuries). QE2 KICK START ECONOMY PHASE 1 Basically $600 billion in longer term treasuries. QE3 We Need More The Fed buys $85 billion a month in both MBS and Treasuries from banks. Then promised rates would stay low! Called forward guidance. Why did they do this? Go back to our example. Suppose R 1 =4%, 1 f 1 =10%, then R 2 =7%. Only way Fed can drive R 2 =5% for example is to promise that 1 f 1 =6%, In other words promise that short rates would stay low! If not, nobody would hold the 5% security, they would sell, P down, rate up defeating the Fed s intention! 35
GAP Management Suppose assets marked up 2%, liabilities down 2% spread 4% a year R1 =.04 R2 =.07, 1 r 1 =.04 Income Expense Profits Pos. GAP.06 +.06.05 +.05.02 0.06 +.06.02 +.02.08 Neg..09 +.09.02 +.02.14 R1 =.04 R2 =.07, 1r1 =.05 Pos..06 +.07.05 +.05.03 0.06 +.07.02 +.03.08 Neg..09 +.09.02 +.03.13 Note the following: when rates rose 1) Pos GAP would cause NII to increase, Neg GAP would cause NII to fall 2) But, had you had a Neg GAP, you could have made more $! So standard GAP games are all about making more $, not maximizing earnings. 36
Interest Forecasting There are three ways to forecast interest rates. 1. Roll your own Nominal rate = real rate + expected inflation Forecast Real GDP 2. Use implied forward rates 3. Look at the futures market Forecast inflation Suppose you (I) think a bushel of corn will sell for $100 a year from now. Would you agree now to sell it to me then for less than $100? Would I agree to pay more than $100? So, the price will end up being close to our best guess of the price. Same is true for the t-bills, fed funds, bonds. 37