Charts and Descriptions

The following describes in detail a few dynamics between economic

variables and interest rates. The examples are chosen from particular periods in the
past to show relationships between driving factors of the interest rate market in the
hopes of shedding light on the market dynamics in play.

Effect of Inflation on Interest Rates

The late 1970s and early 1980s witnessed high inflation in the United States
and around the world stemming from the Mideast oil shocks and rapid expansion
in money supply. The following chart shows the 10-year Treasury interest rate
along with the Consumer Price Index (CPI) measure of inflation.

Note that periods of rising inflation largely coincided with rising interest
rates and vice versa. However, the correspondence is not exact. CPI inflation
peaked earlier than the 10-year Treasury rate and rates remained high even as
inflation declined from nearly 14% to 4%. This disconnect stems from the
important role inflation expectations play in determining longer maturity rates
rather than just the current level. After a decade of high inflation, investors
demanded extra compensation for fixed-rate investments even as current inflation
declined, because expectations of future inflation take longer to dislodge. The Fed
dislodged inflation expectations by sharply curtailing money supply and inducing
a deep recession, which finally lowered rates from double-digit levels. The
dynamic of the late 1970s made central bankers around the world increase
 monitoring of inflation expectations to ensure credibility in their policies and
avoid sustained increases in inflation expectations.

Treasury Yield Reaction to the LTCM

Crisis
The Long-Term Capital Management (LTCM) hedge fund failure led to a
fear of financial system collapse and a resulting flood of liquidity into the
Treasury market in a bid for safety. This lowered Treasury yields across the curve,
as shown in the next chart.

Although yields across maturities declined, the 2-year yield declined

substantially more than the 10-year yield, as is common during flights to safety,
when the demand for liquidity is greatest for shorter-duration securities. In mid-
October 1998, as the situation stabilized, 2-year yields rose again.

Mortgage Refinancing and the Yield

Curve
Mortgage refinancing waves occur when rates decline rapidly and
homeowners take out new mortgages to reduce their monthly payments. The
Mortgage Bankers Association refi index measures the scale of refinancings in the
mortgage market. The chart below shows 2003, when mortgage refinancing
activity spiked in response to low rates.

The year 2003 was one of the classic examples of a refinancing wave, and
there was a sharp reaction for both yields and the curve slope due to mortgage
hedging activity. As mortgage refinancing rises, new mortgages have a greater
duration since they have lower coupons, leading mortgage hedgers to sell
Treasuries/pay in swaps to reduce duration. Furthermore, given that the average
mortgage duration is around 5 to 10 years, this section of the curve has the most
volume of selling/paying, which also steepens the curve. The following chart
shows this phenomenon during the summer of 2003.
Budget Deficits and Treasury Yields
The term federal budget deficit refers to spending by the government in
excess of tax revenues. The deficit determines how much net debt the government
needs to issue to fund expenditures. According to basic rules of supply and
demand, a greater deficit should lead to greater Treasury bond issuance and thus
increase interest rates (higher rates = lower prices for bonds). However, the
dynamic between the deficit and rates is not as straightforward, as the following
chart shows.

This chart shows that yields have been on a mostly downward trend since
1990, even as the deficit has mostly increased since 1999. (Note that in the chart,
the lower the blue line, the greater the deficit.) Yields declined even more rapidly
as the deficit increased sharply in 2008 due to emergency measures by the
government in the wake of the financial crisis. Yields declined throughout the
2000s even with an increasing deficit, possibly because of international capital
flows. Excess savings in emerging markets, such as China, needed investment
destinations, and U.S. Treasuries were a top choice, given their safety and
liquidity. During the credit crunch of 20072008, the flight to quality flows to
Treasuries overwhelmed any effect from the rise in the deficit. Thus, trading
Treasuries to express a view on the budget deficit can be fraught with difficulty.
That is not to say that the deficit is irrelevant; indeed, as fears of increasing
structural deficits from entitlement programs such as social security grow,
Treasury yields are likely to face upward pressure over the coming decades, even
if it is difficult to trade on a weekly or monthly basis based on such a view.