Causes and Implications of Recent Interest Rate Volatility
Long-term interest rates took a roller coaster ride during the summer of 2003. The ten-year constant maturity treasury yield plummeted to a 45-year low on June 13, only to reverse course sharply over the next 45 days (Chart 1). This level of volatility is unusual by historical standards. Typically, such a sharp rise in interest rates is accompanied by strengthening economic data and accelerating inflation. While the emerging economic data were modestly positive over the summer, inflation continued to decelerate from already-low levels.
The short time frame for such a wide interest rate swing was also unusual, given the absence of major events or economic shocks during this period. Clearly, underlying fundamentals cannot explain fully such an abrupt movement in interest rates. So what caused this volatility? The blame probably can be laid at the feet of a "perfect storm" of related factors. The combination of deflation worries, mortgage-related hedging activity, and a rising federal budget deficit, among other factors, likely played a role. This article explores several possible catalysts of the recent increase in interest rate volatility and evaluates the likelihood that a more volatile interest rate environment may persist in the foreseeable future.
Putting Recent Volatility in Context
Before exploring the factors leading to the recent increase in interest rate volatility, it is useful to put it into historical context. As measured by a simple ratio of the standard deviation of the ten-year yield over its mean, interest rate volatility during the first nine months of 2003 was erratic, ranging from 0.01 to .67, compared with 1999 through 2002, when volatility had a much narrower range, between .01 and 0.36.1 Previous periods of high volatility typically have been associated with periods of high inflation, such as that following the second oil shock in 1979 or the 1981- 1982 recession. Certain one-time events, such as the 1987 stock market crash, also appear to be related to increased volatility (see Chart 2).
Deflation Concerns May Have Boosted Interest Rate Volatility
A key difference between the recent economic environment and periods around previous recessions is the historically low levels of inflation and interest rates. In fact, "core inflation," as measured by the consumer price index less food and energy, has fallen continuously, from 2.8 percent in December 2001 to 1.2 percent in September 2003, leading to concerns about outright deflation, or a decline in the overall price level. With economic activity running below its potential for the past two years and historically low rates of capacity utilization in key industry sectors, core consumer price inflation has decelerated (see Chart 3). Typically, disinflation occurs during a recession, as sales drop and retailers are unable to pass on higher prices to customers; however, the low initial rate of inflation and the fact that inflation, as measured, may be overstated lead to expressions of concern about the risks of deflation on the part of the Federal Deposit Insurance Corporation, the Federal Reserve, and private-sector analysts.
In the absence of actual deflation, it is important to note that policymakers' emphasis on this scenario arose from its potentially severe effects on financial institutions and economic activity. The Federal Reserve acknowledged in the official statement after its May 6, 2003, Federal Open Market Committee (FOMC) meeting that "the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The FOMC believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future." This statement was the first to assess the risks of economic growth and inflation separately. Previous FOMC statements had characterized the balance of risks as being in the direction of either economic weakness (low inflation) or excessive inflation (strong growth). This was the first time that the Fed explicitly recognized that price changes could have upside or downside risks, depending on varying conditions of the real economy.
Further, the fact that nominal interest rates cannot practically be set below zero caused certain Federal Reserve officials to give public voice to contingency plans in the event the so-called "zero bound" was reached.2 Certain Federal Reserve officials indicated in widely publicized speeches that in order to gain additional monetary policy traction after the federal funds target rate reached zero, the FOMC might orchestrate purchases of long-dated Treasury notes to "buy down" the long end of the yield curve. Although these discussions clearly were couched in hypothetical language, some bond traders appear to have taken speculative positions in anticipation of such a move. In fact, since the federal funds target rate breached 3 percent, the interest rate floor during the 1991-1992 recession, volatility appears to have risen in conjunction with FOMC meetings (see Chart 4).
A meaningful turning point in the bond market was reached on June 25, when the FOMC announced a 25 basis point cut in the federal funds target rate instead of the 50 basis point cut that many market analysts had been anticipating. It was at this point that bond yields began to rise rapidly, as traders who were betting on lower long-term interest rates moved to liquidate their positions. Since then, heightened interest rate volatility seems to have accompanied the market's anticipation of several FOMC meetings. In the aftermath of the June 25 announcement, statements of Federal Reserve officials no longer referred to the purchase of long-term Treasuries to ward off deflation. Chairman Greenspan's July 15 semiannual monetary policy report to Congress stated that "Given the now highly stimulative stance of monetary and fiscal policy and well-anchored inflation expectations, the Committee concluded that economic fundamentals are such that situations requiring special policy actions are most unlikely to arise."
However, while the Federal Reserve may no longer be considering implementing unconventional monetary policy to ward off deflation, it appears that short-term interest rates could remain unchanged until the U.S. economic recovery develops more fully. According to the statements following the FOMC meetings in August, September, and October, "policy accommodation can be maintained for a considerable period." This statement seems to have had the desired effect of convincing markets that the Fed is serious about staying accommodative until its "predominant concern" about a further fall in inflation has been reduced. With the large output gap and overcapacity, the economy can grow for some time above trend before the excess capacity is worked off and disinflation ceases to be the predominant concern. But how long is a "considerable" period? As long as markets continue to speculate on this issue, interest rates are likely to remain volatile. Such a position was articulated recently by Federal Reserve Bank of Kansas City President Thomas Hoenig, who indicated that the Fed should begin to consider changing interest rates "once the economy achieves sustainable growth with increases in employment and with upward pressure on prices."3 Most analysts expect that the FOMC will maintain a highly accommodative policy stance until significant job growth and accelerating inflation become sustained trends. Still, as the market grapples with the question of what exactly is an "accommodative policy," high interest rate volatility will likely persist.
According to some analysts, another significant contributor to increased interest rate volatility over the summer was the reaction of large holders of mortgage-related assets, such as Fannie Mae and Freddie Mac, to rising interest rates. These companies, along with other large holders of mortgage assets, engage in a risk management technique known as dynamic hedging.
Hedging mortgage-related assets is complicated by the fact that the timing of future cash flows can only be estimated. The timing of cash flows will change as more or fewer mortgage holders decide to prepay their mortgagesa unique feature to this type of debt instrument. This characteristic requires that hedge positions be adjusted as the estimates of the timing of future cash flows change. The adjustment process is referred to as dynamic hedging.
For those homeowners not seeking to liquidate equity, the most important factor governing individuals' decisions to refinance a mortgage is the rate on the mortgage held relative to one that is potentially available. The persistence of low mortgage rates over roughly the past two years led to record levels of refinancing and a steady increase in home ownership. This boom in mortgage originations ultimately resulted in a significant increase in outstanding mortgages and a mortgage market dominated by loans that were originated at rates close to record lows. Another factor of this boom is that the holdings of mortgage-related assets have become more concentrated at fewer, larger companies.4
In mid-June 2003, when mortgage rates began rising from 45-year lows, estimates of the rate at which mortgage holders will prepay their debts fell dramatically. As mortgage rates rise and expected prepayments slow, dynamic hedging strategies require that hedges be adjusted to match new expectations about the timing of future cash flows. As the expected return of mortgage principal moves further into the future, hedge positions are adjusted to compensate. Prepayment estimates, and therefore the expected timing of future cash flows, changed dramatically in mid-June, and large holders of mortgage-related assets moved in concert to adjust hedge positions.
Although maintaining dynamic hedging strategies is complex, involving swaps, futures, and cash market purchase and sales, the theoretical relationship to interest rate volatility can be illustrated by the following example.5 To offset the increasing exposure to rising rates caused by a slower return of principal, a hedger can sell Treasury securities. The decreased demand for Treasury securities embodied by these sales puts downward pressure on their value and pushes Treasury yields higher. The increased volatility of Treasury rates in this example is caused by the fact that rising rates motivated the sale of securities, and the sale of the securities itself pushes rates still higher. When these conditions reverse and interest rates fall, dynamic mortgage hedgers buy Treasuries, pushing prices up and supporting the downward momentum in interest rates. According to a Federal Reserve study, similar behavior among large mortgage asset holders has been enough to amplify movements in Treasury market yields (see Chart 5). The study finds the magnitude of this effect to be an increase in interest rate volatility of between 16 and 30 percent.6
Rising Federal Budget Deficits Also May Be Affecting Interest Rate Volatility
Another factor influencing the interest rate outlook and, possibly, adding to the recent interest rate volatility is the growing size of projected federal budget deficits. A combination of factorsincluding the costs of the wars in Afghanistan and Iraq, the 2001 and 2003 tax cut packages, and the revenue shortfall associated with the 2001 recession and declining equity pricesturned a $255 billion federal budget surplus in 2000 into a projected $480 billion deficit in 2004. The result has been a dramatic increase in the issuance of Treasury debt. In 2000, net retirement of debt by the Treasury was $296 billion, compared with a net issuance of government debt of $258 billion in 2002.
While it is clear that the federal government's demand for credit has risen dramatically, the effect of this increased demand on long-term interest rates is not clear. Leading economists and scholars assert that increases in future deficits raise long-term interest rates. Professor Martin Feldstein of Harvard University, former chairman of the Council of Economic Advisors under President Reagan, explains this concept as follows: "An anticipated future budget deficit means a smaller amount of funds at that future date to finance investment in plant and equipment. Restricting that investment will require a higher real rate of interest. Similarly, the anticipated budget deficit means that individuals will have to be offered a higher yield in the future to induce them to hold the larger amount of government debt in their portfolios. Both of these effects raise the expected future interest rate and therefore they raise the current long-term rate as well."7
Key policymakers also have asserted that higher budget deficits cause interest rates to rise. Even the current chairman of the Council of Economic Advisors, Gregory Mankiw, stated recently that "the budget deficit is a cause for concern it could push up interest rates. But at the moment high interest rates are not the U.S. economy's main problem. Indeed interest rates are very low."8 Finally, Alan Greenspan argued last year that "some of the firmness in long-term interest rates probably is the consequence of the fall of projected budget surpluses and the implied less-rapid paydowns of Treasury debt."9
The widening federal government deficit, and the increased demand for funding it entails, raises concerns about crowding out private investment (see Chart 6). However, given the relatively weak growth in U.S. investment spending in recent years and the still historically low level of interest rates, it is not clear that increased government demand for credit has yet had a meaningful effect on interest rates. As investment spending recovers and the overall demand for credit rises, upward pressure may be applied to interest rates. As markets try to decipher this impact on interest rates, volatility may heighten.
Large Foreign Purchases of Treasuries Add to Interest Rate Concerns
The effect of budget deficits on interest rates presumably would be even more substantial if the United States did not have access to international capital markets. The reduction in national savings from budget deficits manifests itself in both lower domestic investment and more borrowing from abroad. The mirror image of a reduction in net foreign investment is an expansion in the current account.10 If the United States imports more goods and services than it exports or has a current account deficit, then it must be selling assets or borrowing the difference from abroad. The United States has a very large current account deficit, requiring it to borrow from abroad on a massive scale. The shortfall or current account deficit was about $139 billion in second quarter 2003 alone, about 5 percent of gross domestic product (see Chart 7). The United States needs to attract more than $2 billion in foreign capital every working day just to finance the current account deficit. To the extent these foreign inflows are invested in U.S Treasury debt, interest rates are reduced. Large shifts in foreign holdings of U.S. Treasury debt or speculation regarding shifts or the rate of net new purchases could elevate interest rate volatility. The heavy reliance on, and the volatile nature of, international capital may raise interest rate volatility.
Many of this nation's trading partners, particularly in Asia, currently run bilateral trade surpluses with the United States. As they recycle dollars gained in the sale of exports, they typically purchase U.S. Treasury or other lower-risk debt. In addition, after a decade of economic stagnation, Japan continues to follow a policy of intervention in the exchange rate market to limit yen appreciation and thereby encourage Japanese exports. To implement this policy, the Bank of Japan has sold yen and bought dollar-denominated assets, such as U.S. Treasury and agency securities. From January through July 2003 alone, Japan sold about 9.03 trillion yen (U.S. $80.5 billion) and purchased U.S. Treasuries. Japan is the largest foreign holder of U.S. Treasury notes and bonds, with $444 billion out of the $1.39 trillion held abroad as of July 2003. The total amount of Treasury securities outstanding is about $3.5 trillion, so foreign holdings account for about 40 percent of all Treasury debt outstanding.
China is also a large purchaser of U.S. Treasury and agency securities. As it recycles its current account surplus with the United States, China needs large dollar reserves in order to maintain the yuan's dollar peg against speculative attacks and maintain a currency exchange rate peg of 8.3 yuan per dollar. According to the U.S. Treasury, China is the third largest owner of U.S. Treasury bonds, and these holdings surged 23 percent to $126 billion through the fall of 2003 (see Chart 8).
Some economists argue that there is a risk, although small, that if Japan and China ever sold their large Treasury holdings it could cause havoc in the U.S. Treasury market, forcing yields even higher. Volatility could increase should any shift take the form of an abrupt shock, rather than a gradual change in investment strategies. An immediate floating of the Chinese yuan, for example, might engender such a shock. If these nations scaled back their demand for U.S. Treasuries, interest rates could rise. How abruptly rates would rise would depend on the nature of the event. However, it is not clear whether instigating such instability in international currency and bond markets would be advantageous for any of the parties involved. It is most unlikely that either China or Japan would sell their large holdings of Treasuries, considering the negative consequences of such a move on their economies and export markets.
Several factors contributed to the 2003 episode of heightened long-term interest rate volatility. These included deflation worries, mortgage-hedging activity by large holders of mortgage-backed securities, budget deficit concerns, and increased foreign buying of U.S. Treasury debt. The key question is whether these factors will prove to be one-time shocks or permanent fixtures of the interest rate environment going forward. To the extent that deflation concerns fade as the economy gains traction and generates new jobs and inflation pressures build, this factor should fall by the wayside. However, until we reach that stage in the recovery, and markets continue to speculate on when the Federal Reserve will move from an accommodative stance, volatility may persist. Still, other factors may add to interest rate volatility over the next several years. The ever-expanding mortgage-backed securities market and the concentration of holdings at large agencies will likely persist as a potential catalyst of interest rate volatility. Interest in U.S. securities by nations that either run bilateral trade surpluses with the United States or need to invest dollars acquired through currency management activities likely will remain a source of potential volatility. This source may become more pronounced should China choose to float its currency abruptly, or should Japan cease its recent efforts to weaken an appreciating yen. Finally, the growing budget deficit may cause uncertainty about the future course of interest rates and thus may add to volatility whenever budget estimates are revised or developments occur that may affect the outlook for the federal pocketbook.
Maureen Raymond, Senior Financial Economist
1Interest rate volatility is calculated by taking a moving 20-day standard deviation of the ten-year Treasury Note's constant maturity yield divided by the 20-day moving average of that yield. Adjusting volatility for the underlying level of interest rates is indicated by historical evidence suggesting that high-yield periods are apt to witness larger daily deviations than low-yield periods.
2 Ben S. Bernanke, "Deflation: Making Sure 'It' Doesn't Happen Here," remarks before the National Economists Club, Washington, DC, November 21, 2002.
3 Bloomberg. "Hoenig Says 4% Growth Needed to Boost Jobs." October 7, 2003.
4 Since 1998, outstanding mortgage-related debt has expanded more than 10 percent a year. As of June 2003, mortgage securities pools issued by government-sponsored housing enterprises such as Fannie Mae and Freddie Mac totaled $3.2 trillion. Mortgage debt, which accounts for 58 percent of gross domestic product, has reached $6.6 trillion. The derivative positions needed to hedge the prepayment and interest rate risk of these portfolios are massive.
5 See International Monetary Fund, Global Financial Stability Report, World Economic and Financial Surveys. Washington, DC: September 2003.
6 Robert Perli and Brian Sack, "Does Mortgage Hedging Amplify Movements in Long-term Interest Rates?" Washington, DC: Federal Reserve Board, August 2003.
7 Martin S. Feldstein, "The Budget Deficits and the Dollar," NBER Macroeconomic Annual 1986, edited by Stanley Fischer, Cambridge, MA: MIT Press, 1986.
8 Gregory Mankiw, "Deficits could increase rates," Reuters, October 6 , 2003.
9 Alan Greenspan, "The Economy," Remarks at the Bay Area Council Conference, San Francisco, January 11, 2002.
10 The current account is equal to net exports (exports minus imports) of goods and services plus net factor income (interest payments received from abroad minus interest payments made to foreigners from abroad) plus net unilateral transfers (such as direct foreign aid payments).