Term premia in the times of “lift-off”

November 12, 2016

Equilibrium models suggest that as long as the policy rate is firmly near zero, the term premium on longer-dated yields is compressed by a reduced sensitivity of rates to economic change. However, when policy rates are on the move again this sensitivity recovers, while proximity of the zero lower bound implies high economic risks and a surcharge on the term premia. Hence, term premium uncertainty would be highest at the time of “lift-off”, when policy rates are expected to move upward from near zero.

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The impact of U.S. economic data surprises

October 29, 2016

A new paper estimated the short-term effects of U.S. economic data surprises on treasury notes and USD exchange rates over the past 20 years. All of 21 commonly followed data releases produced highly significant surprise effects at least for parts of the sample. However, only non-farm payrolls produced a consistently highly significant impact. After short-term interest rates reached the zero lower bound, the importance of surprises to CPI inflation, housing indicators and weekly jobless claims increased noticeably, possibly related to the Fed’s struggle with its dual mandate.

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Japan’s yield curve control: the basics

October 8, 2016

The Bank of Japan has once again broken new grounds in monetary policy, now targeting not just the short-term policy rate but – within limits – the 10-year JGB yield. In practice the Bank will secure a positive yield curve against the backdrop of negative short-term rates and negative expected long-term real rates. This is meant to mitigate the debilitating effect of yield compression on the financial system and, probably, to contain the risk of bond yield tantrums in case domestic spending and inflation do pick up. As a side effect, the policy would subsidize long duration carry trades and long-long equity-duration risk parity positions.

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Selecting macro factors for trading strategies

September 17, 2016

A powerful statistical method for selecting macro factors for trading strategies is the “Elastic Net”. The method simultaneously selects factors in accordance with their past predictive power and estimates their influence conservatively in order to contain the influence of accidental correlation. Unlike other statistical selection methods, such as “LASSO”, the “Elastic Net” can make use of a large number of correlated factors, a typical feature of economic time series.

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The world’s negative term premium

August 20, 2016

The term premium on the “world government bond yield” has turned decisively negative, according to BIS research. Investors have since 2014 accepted a long-term yield below expected short-term rates, rather than charging a premium on duration exposure. The compression and inversion of term premia may have been fueled by a global duration carry trade and seems to be a global phenomenon. It has coincided with increased correlation of long-term yields across developed and emerging markets.

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The term premium of interest rate swaps

May 7, 2016

A Commerzbank paper proposes a practical way to estimate term premia across interest rate swap markets. The method adjusts conventional yield curves for median error curves, i.e. for recent tendencies of implied future yields to overpredict spot yields. The adjustment produces “neutral curves” or presumed unbiased predictors of future yields. The neutral curves can then be used to back out term premia.

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U.S. natural interest rate stuck at 0%: evidence and consequences

March 12, 2016

Federal Reserve research supports the view that the natural rate of interest in the U.S. has not recovered from its plunge to an unprecedented historical low of close to zero after the great recession. This bodes for protracted problems with the zero lower bound emphasizing the ongoing importance of asset purchases and other non-conventional policy options for central bank credibility.

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The secular decline in the global equilibrium real interest rate

January 2, 2016

A new Bank of England paper finds a 450 bps decline in global equilibrium real interest rates over the past 35 years, due to a fundamental divergence: savings preferences surged on demographics, inequality and EM reserve accumulation, while investment spending was held back by cheapening capital goods and declining government activity. More recently, fear of secular stagnation has compounded the real rate compression.

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Understanding duration feedback loops

October 17, 2015

When long-term government bond yields are low enough, further declines can ‘feed on themselves’. European insurance companies and pension funds are plausible catalysts. The duration gap between their liabilities and assets typically widens non-linearly when yields are low and compressed further, triggering sizeable duration extension flows.

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The deflationary bias of low interest rates

July 12, 2015

Compressed interest rates raise the risk of hitting the zero lower bound. A new theoretical ECB paper shows that even before the ZLB is reached this creates a deflationary bias, as inflation expectations shift lower, real rates rise, and consumption and pricing power decline. To counter this bias central banks would need to accept positive output gaps (tighter labour markets) or even increase their inflation targets.

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