In my previous two posts, I have written about how one might go about interpreting bond market interest rates. The basic scheme I am using is quite traditional and begins by arguing that the nominal yield on risk-free bonds is made up of a real rate of interest plus an adjustment for inflationary expectations.
In the first post, I wrote about inflationary expectations and how one might go about interpreting them. In the second post, I wrote about the expected real rate of interest and how one might go about estimating this measure.
Today, I would like to add something else to the mix, something called the “term premium.” This concept is important and came out in the discussion in the second post when I talked about the influence of risk-averse flows of funds from Europe over the past three years or so that forced market “real” yields, for example, the yield on the Treasury inflation-adjusted securities (TIPS), into negative territory.
Simply defined, the “term premium” includes all other factors that collectively impact a bond yield other than the expected real rate of interest and the expected rate of inflation.
The idea of the term premium has been around for a while but was succinctly explained in a speech by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System on March 1, 2013. This speech can be found on the Board of Governors website.
In his talk, Mr. Bernanke suggested that there were five factors that could impact the nominal bond yield. These five factors are volatility, bond correlations with equities, haven flows, the recycling of current account surpluses and Federal Reserve asset purchases.
Mr. Bernanke did call attention to the fact that these five factors are not mutually exclusive—each can add impact to the other factors, or, work against some or all of the other factors.
Interpreting interest rates is not easy and the factors and their relative weight in influencing yields at any one time can vary given the circumstances and the policy directives of the Federal Reserve, the US Treasury Department, foreign government actions and so on.
And, the understanding of interest rate levels can vary from analyst to analyst depending upon the philosophy and the economic and financial models used by the analysts or by the people who the analysts read and report on.
For example, as reported in my last post, I believe that the “haven” flows of funds has had a tremendous impact on longer-term Treasury yields over the past three years or so. To me, the flow of risk-averse money from Europe and into US Treasury bonds were so great over the past three years that they drove real bond interest rates, the yield on 10-year TIPS for example, below 2.00 percent in late 2009 and below zero-percent in late 2011 where they remained until May of this year.
In May of this year, the yield on the 10-year TIPS broke into positive territory because of the flow of funds out of the US Treasury market back into European bond markets. I believe, that the behavior of yields in these European markets confirms my hypothesis.
Now, here is where interpretation comes into play. Many people believe that the rise in Treasury bond yields this spring resulted from testimony given by Mr. Bernanke on May 22 to the Joint Economic Committee of the US Congress suggesting that the Federal Reserve might begin to “taper” its purchases of securities to something less than the $85 billion being purchased every month. This testimony can also be found on the website of the Board of Governors.
My argument against the impact of the “tapering” announcement is that on May 21, the day before the Congressional testimony, the yield on 10-year TIPS was a negative 34 basis points. On April 5, the yield on 10-year TIPS was at a negative 74 basis points.
That is, there had already been a 40 basis point movement in the yield on TIPS before Mr. Bernanke gave his testimony. The Bernanke testimony may have helped to speed along the rise in yields, but I, for one, do not take this cause to be the predominant factor in the rise in TIPS yields.
And, as I said, different people give different weights to the different factors alluded to above. For example, Mr. Bernanke may give a lot of weight to fifth factor mentioned above, Federal Reserve asset purchases. Therefore, he would argue that the Federal Reserve might have a significant influence on the yield of long-term Treasury securities.
My research and experience leads me to be skeptical that the Federal Reserve can have a significant impact on the yield of long-term Treasury securities so, in searching for reasons why interest rates are where they are, I would not place a lot of emphasis on Federal Reserve purchases of assets.
I am not saying that at some time under some circumstances, Federal Reserve asset purchases might have more than just a short-term influence on long-term interest rates. But, I would not look to this source in my early research to find an explanation for the level of long-term interest rates.
This would not be the case for the yields on short-term Treasury issues.
As I wrote earlier, interpreting interest rate levels and movements is not easy. At times, it is difficult to develop a high degree of confidence in ones interpretation. However, I tend to follow this guiding principle: trust the market first and try and interpret what the market is trying to tell you. Only after pretty well exhausting all of the possible explanations of the current level of interest rates using the assumption of the market being correct do you move on and assume that something else…like Federal Reserve asset purchases…are having a significant impact on yields.
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.