In trying to understand some of the things going on in the fixed-income market I look at several different statistical calculations that sometimes give me a clue as to what might be taking place and what pressures…or lack of pressures exist.
Two such statistical calculations that I work with that I find helpful from time-to-time come from data released by the Federal Reserve System. The specific release I am referring to is the H.15 release titled “Selected Interest Rates” and can be found here.
This information is released weekly every Monday and contains information relating to the week ending the previous Friday. For example, the release from this week is dated October 7, 2013 and contains data through the week ending October 4, 2013.
The two statistical calculations I make from these data are called ratios called the “Liquidity” measure and the “Confidence” measure.
The Liquidity measure is calculated by dividing the yield on the 10-year Treasury constant maturity by the yield on Moody’s seasoned Aaa-rated bonds. The Confidence measure is calculated by dividing the yield on Moody’s seasoned Aaa-rated bonds by the yield on Moody’s seasoned Baa-rated bonds.
The weekly Barron’s magazine publishes a similar measure in its data section called Barron’s Confidence Index. It is the ratio of Barron’s high-grade bond index and Barron’s intermediate-grade bond index. Its performance is roughly the same as the Confidence measure calculated from the Federal Reserve data.
US Treasury securities are traded in the deepest and broadest market of any fixed-income security in the world. US Treasury securities are assumed to be risk-free and serve as a safe-haven investment for investors from around the world. The market for Aaa-rated corporate debt is not as broad and deep as the Treasury market and Aaa-rated bonds are not considered to be as “risk free” as are US Treasury securities.
For the week ending October 4, the yield on the 10-year Treasury security was 2.64 percent. The yield on Moody’s Aaa-rated bonds was 4.58 percent. Thus, the Liquidity measure for the week ending October 4 was 57.6. That is, the yield on the US Treasury security was 57.6 percent of the yield on Moody’s Aaa-rated bonds.
If this measure moves down, the assumption is that the market for fixed-income securities is becoming more liquid because the yield on the US Treasury security will move first before the yield on the high-grade corporate bonds moves. Thus, if the Liquidity measure begins to fall and continues to fall or reaches a level that is below what it previously was, one can argue that the bond market has become more liquid and this indicates that longer-term interest rates, in general will be moving down.
Observing this, one can look further to investigate what has changed in the market that might be causing interest rates to fall.
Several causes of this decline can include the following: the Federal Reserve is injecting more liquidity into financial markets; inflationary expectations are changing; money is flowing into the United States from foreign countries; or, that investors expect that real economic growth will be slower.
Of course, the Liquidity measure can rise, indicating that market liquidity has been reduced for some reason, some of which are the reverse of the examples just given above.
In terms of the current situation, the Liquidity measure remained roughly constant from late last year until late April of this year in the 46.0 percent to 52.0 percent range. In early May, the ratio began to rise as foreign money began to flow out of “safe haven” US Treasury bonds and return to Europe as financial matters on the continent became more settled. In the week ending May 3 the near-term trough was reached for the yield on the 10-year Treasury security.
The Liquidity measure then went through the 52.0 percent upper limit by the end of May and progressed up to over 62.0 percent, the level reached in the week ending September 13, the week that the yield on the 10-year Treasury bond almost hit 3.00 percent.
As almost everyone knows, the next week, Ben Bernanke of the Federal Reserve’s Open Market Committee announced to the world that the Fed would not begin tapering it’s purchases of securities and longer-term yields began to drop. The Liquidity measure dropped modestly as the yield on US Treasury securities fell, indicating more liquidity was now coming into the bond market and the pressure on all yields to rise was lessened.
The Confidence measure records the relationship between the yield on corporate bonds with the highest ratings versus the yield on corporate bonds with the second highest ratings. For the week ending October 4, 2013, the measure stood at 84.7 percent.
As the yield spread narrows between the highest rating versus the second highest rating, the assumption is that the investors are becoming more confident in the economy and, therefore, that the credit difference between the two-types of bonds is smaller. That is, market confidence is higher.
If the yield spread drops then Aaa-rated corporate bonds are seen as possessing less credit risk relative to Baa-rated bonds than before or that Baa-rated bonds were seen as being less credit worthy relative to the Ass-rated bonds.
The interesting thing that was observed over the time period used to examine the Liquidity measure was that the confidence measure did not really change until early August. And, the measure rose through August and September even as the liquidity in the credit markets seemed to be rising as funds flowed from the United States to Europe and longer-term interest rates rose.
That is, the corporate bond market took the rise in interest rates in stride and even, from the late summer into the fall, saw market confidence rise in terms of perceptions of credit risk in the bond markets.
Once can confirm this analysis by also tracking Barron’s confidence index.
So, here are two measures that people can use to try and help them understand what is going on in markets for fixed-income securities. One has to work with them for a while to get a feel for how they can help, but I believe the effort exerted to understand these measures will further help an investor understand what is going on in the world.
About John Mason
John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.