Developing Interest Rate Views Using Macroeconomic Variables

Key economic factors and market events influence interest rate dynamics such as the curvature, level, and steepness of the yield curve and changes in spot versus forward rates. Fixed-income traders use implied forward rates as market-neutral reference points. Active fixed income traders establish their views on developments of future interest rates and position their portfolios in such a manner that they will be able to capitalize on differences between the market consensus and their rate view. Accurate forecasts will lead to greater returns in their portfolios.

The bond risk premium is the expected excess return of a default-free long-term bond less one-period risk-free rate or that of a short-term bond. The bond risk premium is measured using government bonds to capture the uncertainty of default-free rates and is a forward-looking exception that must be estimated.

Research has shown that inflation is a key driver of short and intermediate-term yields, whereas long-term yields are driven by factors such as monetary policy. Monetary policy has an impact on the bond risk premium. During economic expansions, the central banks raise the benchmark rates in a bid to control inflation. The action is consistent with bearish flattening and results in a flatter yield curve since the short-term bond yields rise more than the long-term bond yields. During economic recessions, the monetary authority will reduce benchmark rates to stimulate economic activity. This action is associated with bullish steepening, where the short-term rates fall more than the long-term yields. This results in a steeper term structure.

Central banks have in the past used their balance sheets for large-scale asset purchases. Such asset purchases aim to increase the money supply by buying benchmark bonds and reducing the bond risk premium. The asset purchases impact the term structure by increasing demand in a range of maturity segments. Nations use government bonds to fund their budget deficits. Larger deficits will require more borrowing, which influences the required yield and bond supply. When budget deficits fall, the fiscal supply-side effects affect bond prices and yields by decreasing yields.

Longer government debt maturity structures predict greater excess bond returns. Increased domestic demand reduces the bond risk premium and increases bond prices. Government bond prices are mainly influenced by non-domestic investor demand, which results from either currency exchange rate management actions or holding reserves. Non-domestic flows significantly influence bond prices because outflows down bond prices, raising the bond risk premium.

During uncertain times investors sell off higher risk asset classes and take up default-risk-free government bonds in the flight to quality which is often associated with bullish flattening. To avoid significant portfolio turnover, fixed-income traders often use bond futures contracts. Investors expecting a fall in interest rates will often extend portfolio duration relative to a benchmark to take advantage of bond price rises as the interest rates fall.

To take advantage of a steeper curve where long-term rates rise relative to short-term rates, the trader will short the long-term bonds and purchase the short-term bonds. If the curve is flattening, the trade will purchase the long-term bonds and sell the short-term bonds. Fixed-income investors may alternate long-only investments between bullet portfolios and barbell portfolios. A bullet portfolio is a portfolio concentrated in a single maturity, while a barbell portfolio has both short and long maturities.

Question

Vito Scarletta is a fixed income analyst who expects the Federal Reserve to increase asset purchases of long-term bonds. Which of the following scenarios is consistent with this view? The increased asset purchases will likely:

1. Amplify the effect of increased economic activity on the term spread.
2. Have no effect.
3. Dampen the effect of increased economic activity on the term spread.

Solution

The correct answer is C.

Increased asset purchases signal a positive shift in demand for longer-term bonds, which reduces yields.

Reading 28: The Term Structure and Interest Rate Dynamics.

LOS 28 (k) Explain how key economic factors are used to establish a view on benchmark rates, spreads, and yield curve changes.