The Hindu Business Line : Managing rate expectations, the Fed way

One should remember that interest rates are just not a simple reflection of economic condition, but also driven by expectations of the market players.

THE Federal Reserve has an uncanny ability of managing expectations and preventing systemic risks.

It's a central bank's paramount role, to foresee any signs of risk accumulation and stem any contagion effect. One is reminded of Federal Reserve Chairman's classic `irrational exuberance' speech to calm the surging equity markets in late 1990s.

The Federal Reserve also acted with amazing alacrity to prevent the quick collapse of long term capital markets after the Russian crisis, thereby, preventing a contagion.

It also tried to act in advance by `shouting' deflation middle of last year to prevent such a scenario.

Over the last few years we have been through a period of sub-par global growth and exceptionally low interest rates. The low mortgage rates have led to surge in real estate sector and driven this sector in the US and the UK close to a bubble. Crude oil has touched a 21-year high, with June futures ruling above $41 a barrel.

Bond markets have sold off taking the 10-year Treasury yield from around 4.40 per cent to 4.80 per cent in the last fortnight. One should remember that interest rates are just not a simple reflection of economic condition, but also driven by expectations of the market players.

How is the Federal Reserve gearing for the shift in the stance and would handle the change in yield curve? We would look at the factors affecting the various parts of the yield curve to find the answers.

Short end of yield curve

This is primarily a reflection of the target Fed funds rate or the overnight rate.

The Federal Reserve maintains enough liquidity in the system through sale and purchase of bills and notes to maintain this effective rate. The futures market trades on the expected rate in coming months. Corporates raise short-term money through issue of commercial papers.

Money market funds have been wary of buying commercial papers after a few defaults in the last couple of years.

Corporates have now moved up the curve and reduced demand. Banks lend and borrow in dollars up to one-year tenor at floating rate set daily (Libor). This market also prices in the expectation on change in overnight rates.

Middle of the yield curve

This is the part of the yield curve from 2-10 year tenor. One of the major players in this part is the Administration or the US Treasury. Currently, the Treasury is running a current account deficit of over $500 billion.

Although a large part of this is being met by net inflows into the US, the Government has to resort to huge borrowing.

Unfortunately Iraq war has placed significant strain on the Budget deficit as the expense has run over $85 billion and recently forced the US President to seek another $25 billion.

US Treasury carries out refunding auctions and raises monies through the sale of two, five and 10 year notes.

The quantum of the refunding exercise and the demand determines the yield levels. The success of the auction is measured by the cut-off yield and the bid-cover ratio. In case there is huge demand in the auction, the yield would fall off. The number of times the bid amounts exceed the offer amount indicates the interest in the note.

For example, if in the refunding, the 10-year note saw a bid to cover ratio of 2.38, which was higher than the average of around 2.08 this year, this indicates that there was higher interest. Private sector also raises monies in the similar tenors.

Corporates raise medium term notes and hence the Government competes with the private sector. If the Government's deficit increases and there is a threat of it crowding out the private sector, it would force the interest rates higher. Corporate sector had been caught with excess capital due to the slowdown since 2000 and has slowly worked the excess out.

In case the corporates start aggressively raising capital, it could put strain on the yields. The Federal Reserve closely monitors the deficit and has raised the flag of risk from high deficits in the past.

The members of the monetary policy committee through their speeches have been trying to down play this impact and control expectations.

Long end of the curve

This is the part of the curve which is between 10-30 years tenor. One of the important players in this end are the mortgage players such as Freddie Mac, Ginnie Mae and Fennie Mae. These are pass-through agencies which take on pool of mortgage loans and create the pass through structures and raise money on the mortgage-backed securities (MBS).

These securities trade at a small spread over the US Treasuries. One important characteristic of these securities is their `negative convexity'.

The duration of a bond measures the impact on the underlying price of the asset with change in interest rates. It could also be seen as the effective tenor of the portfolio.

Duration itself changes with interest rates and does not have a liner relationship. Convexity measures the rate of change of duration with interest rates.

Bonds have positive convexity, which implies that in case the interest rates fall, the prices increase at a faster rate and if interest rates move higher, the prices fall at a lower rate.

This is like a cushion to the price risk on an asset portfolio. To understand negative convexity of MBS one has to understand the characteristic of the loans.

In the US, consumers are allowed by statute to repay the mortgage loans if the interest rates fall. In case the interest rates do move lower there are some borrowers who repay the loans and take cheaper ones.

This effectively reduces the duration of the portfolio when things are going in its way.

On the other hand, if the interest rates move higher, the repayment rate would sharply fall thereby increasing the duration and hurting the portfolio when things are going against it.

This negative convexity is handled by these players by selling or buying US Treasuries. The object is to balance the duration of the portfolio. Hence if the interest rates move up, the mortgage funds would have to sell Treasuries to reduce the duration and the impact of higher rates on the portfolio and vice-versa.

One can look at the 10-year US Treasury yield and figure out the likely impact from these players. They do not have to do much if the yield is between 4.20-4.60 per cent.

As soon as it slips out of the range, these players would have to buy or sell the treasuries and thereby accentuate the move.

Given the large growth in mortgage over the past couple years the concern of the Federal Reserve is understandable. They would like to ensure that things change in a "measured pace".

The inflationary expectations play an important role in this part of the curve. If the growth rate is expected to be around three per cent and the inflation is around 1.6 per cent, one would expect the 10-year yield to be around 4.6 per cent.

In case the economy grows at a faster rate or the inflation snares, then the yield expectation would change.

Central banks around the world park some part of the reserves in US Treasuries and push the yield down. Just for reference of the total bid amounts in the treasury refunding over the past year, around 40-45 per cent is from the foreign central banks.

Any shift in expectations from these players would also affect the shape of the yield curve.

One can now appreciate that central banks' role is just not to control immediate liquidity but also to handle expectations on borrowing and inflation.

One important thing is for the Federal Reserve to be not seen to be `behind the curve', that is seen to be reactive rather than proactive.

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)