By analysising the movement in the yield curve of the govement bonds using Bloomberg, it looks like the outlook of the British economy will slow or even decline. However, comparing to the US, the anticipation is a slow down in the next few years, in the long run it will pick up again. Surely, this can not be right. What do you guys think?
I was looking at the US curve a few days ago. I asked a colleague )who has been in the FI world for a while) if there was any ‘signaling effect’ regarding which points of the curve move more than others, and the assumption of the depth of the equity market correction. His response was that basically it comes down to duration and the perceived risk in the rate markets (i.e. buying low duration stuff to immunize your capital against drastic rate moves, or loading up on high duration if you think that). But if I recall correctly, the CFAI stuff basically explains the yield curve shift based on a few different possibilities: rational expectations, market segmentation based on supply/demand, and the preferred habitat. I think that at best, it’s a mix of those. I am sure some banks buy up bonds to match both sides of the balance sheet, and I’m sure some HFs will ‘arbitrage’ the curve when the structure doesn’t match what they expect to happen. But one thing that is interesting is that the Fed Funds rate is above the one year yield. I expect the market is looking for a cutting of the rate (WIRP on bbg for an interesting gander).
Agree on your insight comments. I am just so supprised that the outlook for the US in the long run is better than the UK (based only on the yield curve). Everyone is betting on the Fed cutting the base rate by 50 bp (in fact most of the derivative has allready price this in). Based on many other fundamental factors (weak dollar, huge budge deficit, sub prime mortgage and weak retail figures), the outlook for the US looks in a much worse shape than the UK. Not quite sure why these factors are not reflected.
Was there some CFAI reading that suggested that you could compare the economic outlook for two countries based on comparing their govt bond yield curves? If so, that’s just silly. If not, well, it’s still just silly.
JoeyDVivre: In all due respect to your detail comments, I was expecting more an insight explaination from you on why do you think it is not right. Saying silly that it is not in the CFAI reading, does not really mean anything. After all CFAI only represent a % of all investment knowledge.
theKing, I think that you misinterpreted Joey’s point. He’s saying (quite correctly) that trying to ascertain a country’s future economic outlook by comparing its gov’t bond yield curve to another country’s is preposterous. I second his opinion. "I am just so supprised that the outlook for the US in the long run is better than the UK (based only on the yield curve). " Perhaps explaining how you extrapolated this answer from the data you had would help me understand where you’re coming from. What long run outlook is better? Lower interest rates? Higher? More of a liquidity premium? Less? Regardless of your answer, I fail to see the correlation between any of those parameters and the economic “outlook” of a country, unless we’re defining economic “outlook” differently. Just to clarify, I’m identifying economic “outlook” as a state of the economy, i.e. recession, boom, etc. “But one thing that is interesting is that the Fed Funds rate is above the one year yield.” Now that is a viable economic indicator. Whether you could compare that ratio to LIBOR and the comparable one-year yield in England and see what that tells you would be kind of interesting. [Edit: removed typo in second line.]
skillionaire, I agree with your comments, this level of in depth comments will help someone like me who is not a economic specialist. The initial post was a very high level view, without considering the wider implications. I was trying to gadge on the outlook of the economy by looking only on the yield curves.
I agree with all of what skillionaire said and especially the comments about economic outlook vs interest rates. I think that your reasoning is something like current yield curves reflect expectations for future interest rates and future interest rates are tied to demand for money. Demand for money suggests economic growth and health. Therefore, you can look at two different yield curves and determine the market’s relative view of future economic health. (It’s usually a bad idea to write down what you think someone else is thinking so if I’m totally off-base, just disregard). There are about ten problems in that linkage, but the first is that it relies on some really extreme version of the “expectations” view of interest rates. As you probably know from some CFA readings, the expectations view is the view that yield curves are shaped by expectations of future interest rates. Your view says that not only is that true but that meaningful comparisons can be made between two different yield curves based on both being formed by expectations. The big problems with expectations formation of yield curves is that they don’t account for risk, investor’s attitudes toward risk, and convexity. I found this cool article that might help: http://www.frbatlanta.org/filelegacydocs/fisher.pdf It’s a little on the elementary side and some of it comes across as condescending but there’s some great info in here. Really low interest rates are usually a bad sign for an economy (although nothing too terrible happened in the US in 2003). Generally, it means there just isn’t demand for money which means that there is no economic expansion. High interest rates can mean all kinds of things. In particular, really high interest rates are a sign of total economic disaster as in hyperinflation, currency devaluation, and ruin. In between, there are all kinds of money supply issues that muddy up any conclusions you can draw from interest rates about money demand. This is especially true because the money supply is much easier to change than money demand. The other thing to remember right now is that there is considerable uncertainty about risk premia due to all the structured products and ratings snafus. The tenor and magnitude of that uncertainty and how it affects the relative treasury curves of the US and England is complex and beyond my economic abilities.
Dont forget market segmentation. The UK yield curve is largely dominated by who invests at what point of the curve and has nothing to do with the outlook for interest rates. This is by and large a fuction of supply and demand at each point of the curve, which in turn is a function of legislation and matching assets to liabilities. Put very simply - Pension funds invest in the long end, and as this is where most of money is this forces yields to be lower than the rest of the curve. Insurance funds tend to dominate the middle of the curve - the belly - and the front end is obvisouly anchored at policy rates. There are obviously more dynamics at play than this but these are the reasons that the UK gilt yield curve has been inverted for most of the last 15 years.
JoeyDVivre, no harm taken. You second comment is really the type of information that I was looking for someone like myself who are still quite new to the industry. RS_London, very insightfull comments, I think you are the the buy side analysis.
theKing Wrote: ------------------------------------------------------- > > RS_London, very insightfull comments, I think you > are the the buy side analysis. only until i get my CFA charter 
RS_London Wrote: ------------------------------------------------------- > Dont forget market segmentation. > > The UK yield curve is largely dominated by who > invests at what point of the curve and has nothing > to do with the outlook for interest rates. This is > by and large a fuction of supply and demand at > each point of the curve, which in turn is a > function of legislation and matching assets to > liabilities. > > Put very simply - Pension funds invest in the long > end, and as this is where most of money is this > forces yields to be lower than the rest of the > curve. Insurance funds tend to dominate the middle > of the curve - the belly - and the front end is > obvisouly anchored at policy rates. There are > obviously more dynamics at play than this but > these are the reasons that the UK gilt yield curve > has been inverted for most of the last 15 years. Hmmm…Is it market segmentation or liquidity and convexity? I’m not a big believer in segmentation.
A quick comment on what Joey alluded to above - I do not think the liquidity issues and uncertainty surrounding structures have percolated beyond the 3 month point on the yield curve yet. The very short end is definitely affected (overnight money and commercial paper), rates around 1 yr are definitely not affected yet. But people do seem to think it is a question of time when this will start spilling into the longer tenors.