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Prepared to Tighten

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This note looks at rates and curve dynamics of an eventual imposition of a policy rate tightening cycle.

This note looks at rates and curve dynamics of an eventual imposition of a policy rate tightening cycle.

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  • 1. Prepared to Tighten: Rates and Curve Dynamics During Rate Tightening Cycles Monica M. Kelly Jetskelly1@yahoo.com November, 2009
  • 2. The Rates and Curve Dynamics During Rate Tightening Cycles 1. The Four Recent Episodes of Rate Tightening Cycles 2. The Short Rates Dynamics a. Policy Rate Normalization: Taylor Rule b. Short Rate Normalization 3. The Long Rates Dynamics a. Diminishing Inflation Expectation b. Shift in Portfolio Preference 4. The Curve Dynamics of Rate Tightening Cycles 5. Summary
  • 3. As recent as this month, the Federal Open Market Committee reiterated its pledge to keep the benchmark lending rate, the Federal Funds Rate, at near zero “for an extended period” to boost a weak economic recovery with high unemployment rate. However, given recent signs of positive momentum in manufacturing, retail sales, trades, and housing activities, the Fed Chairman, Ben Bernanke, has begun to introduce expectation of rate tightening. “As economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road,” Bernanke said at a Board of Governors conference on monetary economics in Washington on October 8. “When the economic outlook has improved sufficiently, we will be prepared to tighten.” This note looks at rates and curve dynamics of an eventual imposition of a policy rate tightening cycle. To that end, we would first look at facts and inferences drawn from four recent major episodes of rate tightening cycles. 1. Four Recent Major Episodes of Rate Tightening Cycles: 14 3 Episode 2: Feb 1994 – Feb 1995 Episode 4: Jun 2004 – Jun 2006 Episode 1: Feb 1988 – Feb 1989 Episode 3: Jun 1999 – May 2000 12 2.5 2 10 1.5 8 1 6 0.5 4 0 2 -0.5 0 -1 1/ 9/ 1983 7/ 1/ 1983 1/ 1/ 1 84 7/ 1/ 1984 1/ 1/ 1 92 7/ 9/ 1 92 1/ 0/ 1 93 7/ 1/ 1993 1/ 1/ 2 01 7/ 1/ 2 01 1/ 1/ 2 02 7/ 1/ 2 02 1/ 1/ 2003 1/ 1/ 1985 7/ 1/ 1985 1/ 1/ 1986 7/ 0/ 1 86 1/ / 1 9 7 7/ 9/ 1987 1/ 9/ 1988 7/ 1/ 1 88 1/ 1/ 1989 7/ 1/ 1989 1/ 1/ 1990 7/ 1/ 1990 1/ 1/ 1 91 7/ / 1 1 1/ 9/ 1994 7/ 1/ 1994 1/ 1/ 1995 7/ 1/ 1 95 1/ / 19 6 7/ 1/ 1996 1/ 1/ 1997 7/ 0/ 1997 1/ 1/ 1 98 7/ 9/ 1998 1/ 0/ 1999 7/ 1/ 2099 1/ 1/ 2 00 7/ / 2 0 7/ 0/ 2003 1/ 0/ 2004 7/ 1/ 2 04 1/ / 20 5 7/ 1/ 2005 1/ 1/ 2006 7/ 1/ 2006 1/ 1/ 2 07 7/ 1/ 2007 1/ 1/ 2008 7/ 0/ 2008 /2 9 9 31 98 31 99 31 99 31 00 29 00 31 0 00 3 9 2 9 3 9 3 9 3 0 3 0 3 0 3 0 3 0 7 / 1/ 19 3 9 3 9 2 9 3 0 3 2 3 3 3 3 3 3 3 3 3 3 2 3 3 3 3 3 3 3 3 3 3 3 2 2 3 3 3 3 3 3 3 3 3 1/ 2s10s Slope Fed Funds Rate
  • 4. Rate Tightening Episodes: 1: Feb 1988- Feb 1989 a. The Fed Funds rate hiked 3.25% from 6.5% to 9.75% b. The 2s jumped 2.57% from 7.10% to 9.67% c. The 10s jumped 1.13% from 8.15% to 9.28% 2. Feb 1994 – Feb 1995 a. The Fed Funds rate hiked 3% from 3% to 6% b. The 2s jumped 2.12% from 4.66% to 6.78% c. The 10s jumped 1.07% from 6.13 % to 7.20% 3. June 1999 – May 2000 a. The Fed Funds rate hiked 1.75% from 4.75% to 6.5% b. The 2s jumped 0.85% from 5.51% to 6.36% c. The 10s jumped 0.25% from 5.78% to 6.03% 4. June 2004 – June 2006 a. The Fed Funds rate hiked 4.25% from 1% to 5.25% b. The 2s jumped 2.27% from 2.68% to 4.95% c. The 10s jumped 0.40% from 4.58% to 4.98% In these four major episodes of rate tightening cycles, we observe short rates such as the 2s are substantially more sensitive to policy rate changes than the long rates such as the 10s. The eventual rise in the 2-year yields were larger in magnitude than the rise in the 10- year yields; on average, the 2-year yield normalized 3/4 of the magnitude of the rate tightening during the rate hike cycles while the 10s normalized only 1/3 of the rate hikes, causing the 2s 10s slope to flatten in an upward directionality. In fact, by the end of the four tightening cycles, the FFs10s slope had completely inverted in three of the four episodes. Treasury Rates and Curves In Recent Rate Hike Episodes 3/1988-2/1989 2/1994-2/1995 6/1999 - 5/2000 6/2004-6/2006 Start End Rate/Slope Chg Start End Rate/Slope Chg Start End Rate/Slope Chg Start End Rate/Slope Chg FF 6.75 9.75 3.00 3.25 6 2.75 5 6.5 1.5 1.25 5.25 4 2s 7.10 9.67 2.57 4.66 6.78 2.12 5.51 6.36 0.85 2.68 4.95 2.27 10s 8.15 9.28 1.13 6.13 7.20 1.07 5.78 6.03 0.25 4.58 4.98 0.40 ff-2s slope 0.35 -0.08 1.41 0.78 0.51 -0.14 1.43 -0.30 2s10s Slope (%) 1.16 -0.39 1.47 0.42 0.27 -0.33 1.90 0.03
  • 5. Now that we have observed the changing dynamic of the treasury curve is predominantly a bearish flattening dynamic which begins at the end of an on-hold policy cycle and onward into a policy tightening cycle, and that the changing curve dynamic is primarily led by the front end more so than the long end of the curve. One would have to ask, what drives the different normalization paths between the short and long rates during policy rate tightening cycles? 2. The Short Rate Dynamics Empirical observation we established earlier that short term interest rates such as the 2s are substantially more sensitive to policy rate changes than the longer end. A few inferences can be drawn: 1) US policy rate, the Fed Funds Target Rate, and the 2y UST yield tend to move in tandem as demonstrated in the graph below. This co-movement pattern implies a strong rate directionality between the Fed Funds Rate and the 2y UST yield. 2) Despite their strong rate directionality, the normalization processes of the US policy rate and the 2y UST yield run at different speeds once the policy rate tightening cycle begins. As aforementioned, on average, the 2-year yield did not completely normalize the rate hikes, it only normalized 3/4 of the rate tightening during previous policy rate hike cycles, some of the short rate normalization had already happened while the Fed remained on-hold. 3) Policy rate normalization expectation drives the short rate dynamics once the rate tightening cycle begins. To understand the short rate dynamics during rate hike cycles, one has to understand policy rate normalization drivers. Policy Rate and Short Term Rate 25 20 15 10 5 0 10/30/1981 11/30/1982 12/30/1983 10/31/1994 11/30/1995 12/31/1996 10/31/2007 11/28/2008 8/31/1979 9/30/1980 2/28/1986 4/29/1988 5/31/1989 6/29/1990 7/31/1991 8/31/1992 9/30/1993 2/26/1999 3/31/2000 4/30/2001 5/31/2002 6/30/2003 8/31/2005 1/31/1985 3/31/1987 1/30/1998 7/30/2004 9/29/2006 Fed Funds 2Y UST Source: Citi
  • 6. a) Policy Rate Normalization The macroeconomic approach to analyze the policy rate normalization process is based on a well-established monetary policy rule known as the Taylor rule which suggests the equilibrium policy rate is a function of the steady state policy rate, real economic output gaps, and inflation rates gaps from long term growth and inflation potentials and targets. By incorporating forward looking macroeconomic forecasts such as growth and inflation rate forecasts to assess near term output and inflation gaps, depending on the direction of the gaps, widening or narrowing, the Taylor policy rule provides an approximation of an equilibrium policy rate normalization trajectory on how the central banks balance the competing monetary goals in setting an appropriate level of monetary policy rate. As the economy currently is at the trough of an economic down cycle, and the policy rate is at record low, a gradual revival in aggregate demand and hence economic growth will begin to narrow the output and inflation gaps as macroeconomic activities are gradually approaching toward near term capacities and targets. Central banks would begin to consider policy rate tightening as the diminishing output and inflation gaps from potential will increase market expectation of inflationary pressure. Rational investors will begin to expect higher yield and return compensation for higher income growth, inflation, and policy rate expectation, and this higher expectation will translate into a sharp upward repricing of the short rates. In the two months prior to the 2004-2006 rate hike cycle, the 2y UST yield jumped nearly 1%, the yield slope between the 2s and FFs jumped from 0.57% in Mar 2004 to 1.53% in May 2004, ahead of the start of the rate hike in June 2004. b) Short Rate Normalization Paths The charts below show the path of short rate normalization is highly dependent on that of policy rate normalization. 1) An anticipated rate tightening will drive the market to begin to normalize the short rate prior to rate hikes. In the last two rate hike cycles, the market has already normalized 30% of the eventual moves in the short rates when the rate cycles began. 2) A gradual steady fine tuning policy rate normalization process such as in rate hike episode 4 (2004-2006) during which 17 25bps rate hikes within 24 months policy cycle dictated a slow and smooth short rate normalization path. On the other hand, the 7 rate hikes ranged between 25-75bps within 13-month tightening cycle in Episode 2 (1994-1995) brought about a more volatile path of short rate normalization. The short rate even overshot the normalization path before the rate hike cycle ended. While in Episode 1, rate hikes ranged between 12.5bps to 1%, the pause in the middle of the rate hike cycle wrongly gave the market a policy ending signal, and the short rate normalization path reverted, only to pick up with accelerated speed and heightened volatilities. This suggests if central banks would like to see a steadier short rate normalization and to reduce market volatilities, policy makers should give regular and unambiguous signals to the market in their policy communiqués to guide market expectation of policy rate normalization.
  • 7. Rate Hike Episode 1: Feb 1988 - Feb 1989 Rate Hike Episode 2: Feb 1994 - Feb 1995 100% 150% 130% 80% 110% 60% 90% 40% 70% 50% 20% 30% 0% 10% -10% 4 4 4 94 4 5 4 4 4 4 4 4 5 88 88 88 8 8 8 8 8 8 9 8 9 99 99 99 99 99 99 99 99 99 99 99 99 98 98 98 98 98 98 98 98 98 19 19 19 19 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 /1 1/ 0/ 0/ / 29 31 31 30 29 31 30 31 28 1 0 0 28 31 29 31 30 31 30 28 29 31 /3 /3 /3 /3 /3 /3 4/ 5/ 6/ 9/ 1/ 3/ 7/ 8/ 2/ 10 11 12 2/ 3/ 4/ 5/ 6/ 7/ 8/ 9/ 1/ 2/ 10 11 12 Policy Rate Normalization Short Rate (2Y UST) Normalization Policy Rate Normalization Short Rate (2Y UST) Normalization Rate Hike Episode 3: Jun 1999 - May 2000 Rate Hike Episode 4: Jun 2004 - Jun 2006 100% 100% 80% 80% 60% 60% 40% 20% 40% 0% 20% 29 0 9 31 9 30 9 30 9 31 9 30 9 9 9 31 9 31 0 28 0 31 0 0 99 99 99 99 99 10 99 00 00 00 00 00 11 99 12 99 9 19 0% /2 1 /1 /1 /1 /1 /1 /1 1 /2 /2 /2 /2 0/ 1/ 9/ 30 /2 /3 /3 4 0 0 4 /3 /2 0 9 0 0 4 /3 /2 0 2 8 0 5 /2 /2 0 7/2 /2 0 9 0 5 12 0 0 5 /3 /2 0 5 1/2 0 /3 0 6 1/ 4/ 5/ 6/ 7/ 8/ 9/ 2/ 3/ 4/ 5/ Policy Rate Normalization Short Rate (2Y UST) Normalization Policy Rate Normalization Short Rate (2Y UST) Normalization Data source: Bloomberg
  • 8. 3. The Long Rate Dynamics Earlier we established that across the various previous rate hike cycles, the longer rates such as the 10y UST yield rose, on average, only 1/3 in the magnitude of the eventual policy rate normalization. This rise in long term rate is quite modest compared to the rise in short term rate we examined earlier, leading the short and intermediate curve to bearish flattening. One may ask, why is the rise in long rate relatively modest when policy rate tightens? What drives this relatively long term yield stickiness? There are various conventional explanations, and the relative long term yield stickiness during rate tightening cycles is largely a recent phenomenon. a. Diminishing inflation expectation Even though longer rate movements are not as sensitive to policy rate normalization during rate hike cycles, the influence of the monetary policy may also not be underestimated. In particular, monetary policy credibility, especially in its effectiveness in controlling inflationary pressure in an economic up cycle, can influence on the level and rise of long-term rates via its impact on inflation expectations and term premia. Conventional models in general decompose long-term rates into the following components: 1) the expected short-term real interest rate; 2) inflation expectation; 3) a combination of term, liquidity and risk premia associated with the bonds’ maturity, issuer, and market conditions. As previous section focused on the short term rate dynamics, here we focus on the second and third components of long term rates. We support the conventional argument that a well-established monetary policy credibility is a powerful tool in anchoring market expectation of inflation and risk premia. If policy rates are expected to return to the neutral level once any cyclical and inflation shocks have run their course, and if the market believes that long-term inflation expectations are well anchored with monetary tightening policies, a diminished perceived inflation risk, and with lower associated volatility of prices and output, during central banks’ rate tightening cycles, are key contributors to the stickiness of long-term yields via a narrowing in inflation and risk term premia as investors demand lower term premia to hold long-term securities. The graph below demonstrates that in periods preceded the rate hike cycle of 2004-2006, inflation expectation gap (the difference between breakeven rates and core PCE) exceeded 1%, followed by a gradual moderation when the rate hike cycle began and eventually that inflation expectation gap fell to zero by the end of the policy cycle. That is, the rate tightening was effective in reducing expectation gap until inflation expectation became consistent with realized inflation rate.
  • 9. Data source: Bloomberg b. Shift in Portfolio Preference In addition to the repricing of long term yields with moderating inflation risk and term premia in an economic up cycle coincided with a rate tightening cycle, long term yields are also influenced by portfolio shifts by changing investor demands. In facing with moderating inflation risk and term premia due to stabilizing output and prices, long term real yields may rise if nominal yields are deflated by lower inflation risk and term premia, we expect to see a demand shift from yield-focused private-sourced investors towards longer-dated securities in search of higher yields. Recent stronger than expected bids for long term US Treasury auctions suggest that this demand shift is already underway. This shift in portfolio preference towards longer-dated securities in a rate hike cycle can be attributed to two key investor rationalities: 1) Enhancing portfolio returns: In anticipating an overall rise in interest rates and higher costs of borrowing, investors’ desire to enhance portfolio return would lead to increase investment in higher yielding securities. Within the rates market, while the slope of the curve is still reasonably steep and provides attractive rolldown in the early cycle of the rate tightening, the desire for higher yields outweighs the concerns for duration risk if investors expect policy rate normalization process to be gradual, leading to extending out along the curve to invest in longer-dated securities. The yield-focused shift in portfolio preference hence increases demand for longer- dated securities, and helps drive the longer term yield lower and curve flatter as the rate tightening continues.
  • 10. 2) Cushioning price volatility: Bonds with yields well above prevailing interest rates are sometimes called cushion bonds, because these bonds help to cushion against falling prices when rates rise. All factors equal, bonds with higher yields will be less volatile than bonds with low yields due to the convexity of the price/yield relationship. In anticipating a rising interest rate environment, investors would also shift portfolio preference towards securities with relatively lower yield volatility by seeking above prevailing yields. We expect to see higher coupon rate bonds to outperform lower coupon bonds given the same maturity structure due to their more desirable duration and convexity properties in immunizing a rising interest rate environment. The demand for long term treasury securities from official capital flows from countries with foreign reserves accumulated in US dollar remains one of the important factors compressing term premia and flattening the yield curve in recent years. These types of investment flows toward long term Treasury securities are relatively price inelastic and remain substantial, most notably created the so called “bond conundrum” phenomenon during the 2004-2006 rate hike cycle. Although there were occasional discussions of the desire of Asian countries to diversify their reserve accumulation away from US dollars or US Treasury securities, given their large current account deficits with the US and their reliance on trade with the US market, recent strong bids from indirect bidders in US Treasury auctions suggest that any such discussions of diversifying away from US Treasury securities remain largely rhetorical. 4. The Curve Dynamics of the Rate Hike Cycles We observe the changing curve dynamics of the 2s10s slope are sensitive to the starting slope of the curve in the last four episodes of rate hikes as shown in the graph below: 1) If the curve started off relatively flat, such as in Episode 3 where the 2s10s curve was only 27bps when the rate hike cycle began, a majority of the changing curve moves was largely followed by bearish parallel moves first, the ending dynamics were of corrective bullish flattening led by the long end of the curve; 2) If the curve slope has steepened prior to rate hike cycles as in Episode 1, 2, and 4, then the curve dynamics will be dominated with bearish flattening in the following order: a) An initial period of bearish parallel moves in anticipating of overall higher interest rate environment; b) Protracted period of gradual bearish flattening moves led by front end with higher policy rate expectation punctuated with bearish parallel shifts driven by positive growth factors and supply concessions; c) Corrective bullish flattening moves led by long end as the short end is anchored by higher rate expectations and the long rates are driven lower by lower inflation risk premia and shift in portfolio preference for longer-dated securities; d) Corrective bullish/bearish steepening if rates overshoot at the end of the rate cycles.
  • 11. Curve Dynamics 2.5 2 2s10s Slope (%) 1.5 1 0.5 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 -0.5 -1 Rate Hike Schedules Episode 1 Episode 2 Episode 3 Episode 4 Data source: Bloomberg 5. Summary As we have attempted to establish so far the next sustainable move in the US Treasury yield curve is of a protracted bearish flattening dynamic prior to and during rate hike cycles, With those said, one also needs to differentiate between policy tightening from policy rate hiking in coming months given many of the unorthodox liquidity facilities used by the Fed in this credit easing cycle. The Fed can tighten by unwinding many of its easing programs before it begins hiking interest rate. In fact, the Fed has begun to do so. The Fed’s balance sheet shows its liquidity facilities have shrunk from a peak of $1.6tr in Dec 2008 to $366bn in October 2009, although certain programs such as TALF remains in place to support consumer residential and commercial asset-backed securities. The Fed’s exit strategy has begun. In summary, we expect to see a sharp upward re-pricing of the short end as soon as the market expects the risk of policy tightening move drawing near. Once an eventual turn of the cycle into a tightening one, we should then expect protracted parallel shifts higher in yields, punctuated by smaller corrective bull flattening biases. The net effect is a substantial flattening of the curve and higher rates, but the actual curve dynamic we shall likely see is bull flattening with parallel bearish moves.
  • 12. References: Bloomberg, http://www.Bloomberg.com The Federal Reserve Board, http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm Mark Schofield, “Duration and the Yield Curve – the Slow Process of Normalisation of the Term Structure,” The International Interest Rate Strategist, Citi, 21 August 2009. John B Taylor, “Monetary Policy Rules,” NBER-Business Cycles Series, Vol 31, 1999.