Interest Rate Markets by Siddhartha Jha

Author:Siddhartha Jha
Language: eng
Format: epub
ISBN: 9781118017791
Publisher: Wiley
Published: 2011-02-08T16:00:00+00:00

Flight to Quality

An important, if unpredictable, short-term factor for Treasury yields is a flight to quality. Although economic cycles have their ups and downs, financial systems can encounter shocks that suddenly increase the risk premium in most assets. The market goes through phases of being comfortable with risk followed by bouts of risk aversion that lead to profit taking on winning trades and a flight back to safe assets. A variety of assets can be touted as “safe,” such as certain currencies and gold, but Treasuries by far remain the product of choice. This is not necessarily because Treasuries are safer than gold, but more because of their liquidity. Given the ease with which money can flow in and out of Treasuries, they attract funds during stress times while investors try to avoid losses in more exposed risk markets. These swings in psychology can be very difficult to anticipate, but for Treasury yields, a negative shift in sentiment can cause yields to trade much lower than fair value estimates of Treasury yields relative to supply and demand and Fed policy. An episode of risk aversion may lower expectations of future economic growth, but the rush to Treasuries tends to be much more rapid than any reassessment of economic growth. Instead, the rush for safety and liquidity tends to be an overreaction and fades rapidly. It is exceedingly difficult to estimate “fair value” of yields in such a stress situation, as part of the yield premium is driven by weak economic prospects and part by excess funds flooding into safe assets.

Market risk aversion has effects not just on the level of yields but also on the shape of the yield curve. As funds flee from riskier assets, the sectors at the front end receive the greatest amount of flows, given their easy access for liquidity purposes. This situation was starkly evident in the T-bill market in late 2008, where shorter-end bills traded at negative yields. Across the yield curve, then, there tends to be a steepening effect. Longer-end rates tend to decline as well, but the extent of the decline is determined by the severity of the crisis; for more severe crises, the expectation of prolonged weak economic growth can cause longer-end rates to head successively lower after the front end does not have any lower to go. For example, the Long-Term Capital Management crisis caused a decline of 149 bps for 2-year rates and 96 bps for 10-year rates between the end of July and the end of October 1998. In the credit crunch, the severity of this crisis led 2-year rates to all-time lows. Ten-year rates then followed on a lagged basis as prospects of economic growth stayed gloomy until March 2009. As the economy showed signs of improvement, both rates headed higher, but this time, the 10-year rate led the charge. As discussed earlier, 10-year rates are linked to longer-term economic prospects; 2-year rates are far more linked to near-term Fed monetary policy, which was expected to stay on hold for 2010.

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