What Is The Yield Curve? Why Is It Important? 9
Let’s conclude our discussion on the yield curve with the role of central banks, namely the Fed.
Where is the Fed, and it’s supposed control over interest rates in the previous parts of our discussion?
Central bank policy’s effect on rates is slightly more difficult to understand due to the widespread myths that surround it. The vast majority of market participants believe that the Fed (and other central banks) control interest rates, and as such, believe that rates move on their whim.
In practical terms, this translates into two different forces.
The first is traders and investors reacting to the Fed, driven by their belief that what the Fed does matters. This is easily observed by rates surging or plummeting immediately after the FOMC makes a policy announcement. (Or a voting FOMC member makes a speech).
The second is, of course, what traders and investors in the US Treasury (UST) markets are actually doing, which is a combination of a whole host of complex factors and interactions.
These include, but are not limited to, the demand for collateral in the global financial system, participants’ outlook for interest rates, how financial institutions are hedging their books, and the supply of USTs auctioned into the market by the government, to name a few.
A simple way to grasp how the two forces, reactions and what the market is actually doing, are interacting with each other is to use the Iceberg Model.
Fed announcements and policy changes are represented by “Events”, which are the most visible part of a complex system, hence why everyone talks and writes about them.
What the market is actually doing is represented by “Patterns Of Behavior”, which in the context of markets, refers to trends.
If interest rates, that is yields, not bond prices (the two are inversely related) are trending higher prior to a Fed announcement, we know that it is more than likely that they will continue to trend higher.
Because, as mentioned earlier, what the Fed does doesn’t really matter.
This can be empirically observed by looking at turning points in US 2y yields and the Fed Funds Rate. Historically, the Fed has lagged the UST market.
In other words, the Patterns Of Behavior, i.e. trends, in the market matter more than the Events.
How does all of this relate to the shape of the yield curve?
To be concluded…
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